UC-NRLF 


$B  260  sm 


FUNDAMENTAL^*^ 


COST<7/9  prof™ 

CALCULATION  ^^M 


DENHAM 


Digitized  by  the  Internet  Archive 

in  2007  with  funding  from 

IVIicrosoft  Corporation 


http://www.archive.org/details/fundamentalsofcoOOdenhrich 


FUNDAMENTALS  OF 

COST  an5  profit 

CALCULATION 


By 

Robert  S.  Denham 

Chief  Engineer,  The  Denham  Costfinding  Co, 

Cost  Engineers,  Cleveland,  Ohio 

Author  of 

Practical  Cost  Engineering, 

Manual  of  Cost  Engineering  and  Estimating, 

The  Science  of  Costfinding^  The  A-B-C 

of  Cost  Engineering,  Etc,  Etc, 

Revised  Edition 


CLEVELAND 

Cost  Engineer  Publishing  Co. 

1919 


',6^^ 


v^vV-aV^  "^^^ 


Copyright  1918 

Copyright  1919 

By  ROBERT  S.  DENHAM 

International  Copyright 

All  Rights  Reserved 


"         •    *       •      e  c 


Printed  by 
Gardner  Printing  Co. 

Binding  by 

Forest  City  Bookbinding  Co. 

Cleveland 


PREFACE 

Mr.  Business  Man: 

This  book  is  written  for  you.  It  is  in- 
tended to  help  you  to  throw  the  searchlight  of 
analysis  into  those  recesses  of  your  business 
heretofore  darkened  by  the  cobwebbed  tradi- 
tions and  formulas  handed  down  from  the 
age  of  the  tallow  candle,  the  ox  cart  and  the 
quill  pen. 

The  two  most  vital  factors  in  business  are 
Cost  and  Profit,  but  few  there  are  who  can,  in 
any  transaction,  define  the  point  where  the 
elements  of  Cost  cease  to  accumulate,  and 
Profit  becomes  a  reality. 

It  is  extremely  important,  now  more  than 
at  any  other  time  in  the  history  of  America, 
that  business  men  know  the  cost  of  doing 
business,  the  cost  of  manufacture,  the  cost  of 
distribution,  and  the  extent  of  the  profits  in 
the  business. 

Thousands  of  concerns  not  profitably  con- 
ducted are  forced  to  pay  taxes  on  profits 
which  do  not  exist,  because  unthinking  and 
misinformed  accountants  have  established 
incorrect  methods  of  calculation.  For  the 
same  reason  others  who  should  pay  taxes  will 
go  free. 

Every  business  should  be  profitably  con- 
ducted.   Every  business  should  pay  its  fair 


405503 


r      »r' 


"  '   '  '  '  ''    •  *  .. '  c  'Preface 

share  into  the  treasury  of  the  nation  and 
state;  but  how  shall  there  be  certainty  as  to 
profitableness  when  the  ancient  methods  of 
calculation  in  common  use  are  misleading? 
How  shall  fairness  and  justice  be  upheld 
when  costs  and  profit  in  modern  business  are 
calculated  by  methods  which  have  been  obso- 
lete for  generations? 

We  are  confronted  today,  in  a  time  of  seri- 
ous concern,  with  the  deplorable  facts  that 
the  accounting  profession  has  clung  too  long 
to  its  ancient  formulas;  that  it  has  offered  no 
practical  solution  for  many  of  the  more  im- 
portant industrial  and  commercial  problems; 
and  that  there  is  no  evidence  that  it  is  now 
engaged  in  any  recognizable  effort  to  meet 
the  needs  of  the  hour. 

The  author  offers  no  apology  for  breaking 
away  from  traditional  methods.  He  is  ham- 
pered by  no  "professional  ethics"  which  for- 
bid departure  from  so-called  "standard  ac- 
counting practice,"  thereby  destroying  initia- 
tive and  balking  progressive  development, 
but  discarding  precedents,  breaking  the  idols 
of  "authorities"  whose  theories  date  back  to 
other  times  when  conditions  were  simpler 
than  now,  he  places  every  problem  of  Cost 
under  the  test  of  logical  analysis. 

4 


PTeface 

The  crying  need  is  for  facts:  the  facts  of 
cost,  the  facts  of  profits,  not  the  camouflage 
of  meaningless,  mythical  phrases  such  as  cost 
accounting  offers  in  "prime  cost,"  "factory 
cost,"  "labor  cost"  and  "gross  profit,"  nor  the 
Stygian  mystery  of  that  cesspool  of  ignorance 
"overhead  expense." 

Every  element  of  expense  is  definite,  in 
amount,  in  purpose  and  in  benefit.  The  line 
between  loss  and  profit  in  every  transaction 
can  be  known  within  a  fraction  of  one  per 
cent.  The  profit  on  each  sale  and  on  the  busi- 
ness as  a  whole  can  be  accurately  determined, 
if  you  know  how. 

But  the  ancient  methods  must  be  dis- 
carded. The  uncertainty  of  "overhead"  and 
"gross  profit"  must  give  way  to  the  definite- 
ness  of  practical  Cost  Engineering.  Theories 
and  formulas  must  be  replaced  by  analysis 
and  reason.  There  must  be  coordination  be- 
tween modern  business  and  methods  of  calcu- 
lation. 

It  is  the  purpose  of  the  author  to  show 
insofar  as  the  limitations  of  this  popular- 
priced  book  will  permit,  what  the  elements 
of  cost  are,  the  correct  rules  for  calculation, 
grouping  and  distribution  of  same,  the  cor- 
rect methods  of  determining  the  cost  of  pro- 

5 


Preface 

duction  in  factories  and  the  cost  of  merchan- 
dising. 

In  view  of  the  fact  that  practically  all 
school  textbooks  teach  incorrect  methods  of 
calculating  profits,  and  not  to  exceed  ten  per 
cent  of  those  whose  duties  include  the  making 
of  selling  prices  know  the  correct  method,  a 
chapter  on  that  subject  will  be  included. 

The  aim  will  be  to  make  each  statement  as 
clear  as  possible,  to  back  up  each  recommen- 
dation with  the  reason  for  its  presentation, 
and  where  truth  and  justice  will  be  served  by 
digression  from  the  traditional  methods  in 
common  use,  to  convince  the  reader  that  the 
difference  is  not  only  justifiable  but  worthy  of 
acceptance. 

Further,  the  author  hopes  to  leave  in  the 
mind  of  every  reader  the  impression  that  the 
information  he  has  gained  is  not  only  worth 
the  expense  and  time  required  to  obtain  it,  but 
that  it  will  in  a  practical  manner  serve  as  a 
basis  for  more  successful  business  methods  in 
the  future,  so  that  profits  may  be  developed 
from  hitherto  unprofitable  sources,  and  per- 
manent good  will  established. 

Sincerely, 

THE  AUTHOR. 

6 


CONTENTS 
Preface  3 

1.  The  Philosophy  of  Cost  and  Profit 9 

2.  Direct  Expenses 19 

3.  Indirect  Expenses 29 

4.  Economic  Expenses 43 

5.  Determining  Cost 59 

6.  Selling  Prices  and  Profits 77 

7.  Making  Cost  and  Profit  Statements 95 

8.  The  Terminology  of  Cost  Engineering..  105 

Index  of  Terminology 116 

General  Index 117 


^^One  of  the  first  things  that  a 
man  has  to  learn  in  business  is 
how  little  he  can  do  by  himself. 
When  he  finds  that  out  he  be- 
gins to  look  around  for  people 
to  do  what  he  can't!' — Henry 
Ford. 


CHAPTER  ONE 

THE  PHILOSOPHY  OF  COST 
AND  PROFIT 

What  is  Cost? 

Wc  grow  so  accustomed  to  the  use  of  com- 
mon words  that  we  rarely  stop  to  consider 
their  definitions.  In  fact  we  consult  the  dic- 
tionary, as  a  rule,  only  when  we  encounter 
some  word  that  is  new,  or  that  is  used  in  an 
unfamiliar  sense.  As  a  matter  of  fact  there 
are  many  words  in  common  use  by  persons 
who  should  know  better,  that  are  used  with- 
out thought  of  their  true  meaning.  One  of 
these  is  "cost." 

We  hear  the  merchant  speak  of  his  "cost" 
when  he  has  reference  to  the  amount  charged 
him  in  the  invoice  for  the  item,  without  re- 
gard to  the  other  expenses  which  have  been 
involved  in  carriage,  warehousing,  protecting 
and  handling  the  goods. 

We  hear  the  manufacturer  use  the  term 
"actual  cost"  when  he  has  in  mind  only  the 
elements  of  material  and  wages  paid  the 
workers  who  are  directly  engaged  in  the  pro- 
duction of  the  item  under  consideration. 


Fundamentals  of  Cost  and  Profit  Calculation 

We  hear  the  accountant  glibly  talk  of 
"prime  cost"  when  he  has  in  mind  the  same 
elements,  and  of  "overhead  cost"  when  he 
refers  to  the  other  expenses  involved  in  the 
operation  of  the  factory  and  the  distribution 
of  its  product. 

It  is  possible  to  convey  information  clearly 
and  definitely  from  one  mind  to  another  only 
when  each  speaks  the  same  language  and 
understands  the  meaning  or  definitions  of  the 
words  used,  therefore  the  author  requests  the 
reader  to  follow  carefully  the  definitions  pre- 
sented herewith,  that  he  may  fully  understand 
the  viewpoints  and  methods  presented. 

The  cost  of  an  item  of  product  is  the  sum 
of  the  expenses  involved  in  its  production  and 
distribution  up  to  the  moment  at  which  cost 
is  determined. 

This  is  the  first  fundamental  principle  of 
Cost  Engineering. 

Cost  is  the  sum  of  certain  expenses.  Being 
a  sum  it  must  be  a  definite  amount.  Two 
methods,  therefore,  which  produce  different 
results  in  the  effort  to  determine  cost,  cannot 
both  be  correct.  Both  may  be  wrong,  or  one 
may  be  right  and  the  other  wrong. 

Expenses  are  the  elements  of  cost.     Part 
10 


The  Philosophy  of  Cost  and  Profit 

of  the  expenses  cannot  be  cost.  Cost  is  noth- 
ing less  than  the  sum  of  all  of  its  elements.  If 
a  cent  is  omitted,  or  a  cent  included  that  is  not 
involved  in  the  production  of  the  item  under 
consideration,  cost  has  not  been  determined 
correctly. 

The  expenses  of  a  business,  or  of  the 
operation  of  a  factory,  are  definite,  and  lim- 
ited. It  is  possible  to  so  analyze  these  ele- 
ments that  each  may  be  exactly  known.  The 
total  is  then  easily  ascertainable. 

When  the  items  of  product  of  the  factory 
differ  in  size  or  character  it  is  necessary  to 
know  definitely  the  cost  of  each  lot  of  like 
items  produced.  If  one  lot  or  item  has  been 
charged  with  expense  which  belongs  on  other 
product,  an  overcharge  exists,  not  only  de- 
stroying the  accuracy  of  the  result  in  connec- 
tion with  the  item  under  consideration,  but 
preventing  correct  determination  of  cost  on 
the  items  which  should  have  borne  the  amount 
thus  overcharged.  The  sum  of  the  costs  on 
individual  lots  of  product  for  a  given  period 
should  equal  the  total  of  the  expenses  involved 
for  the  same  period. 

The  problem  presented  by  a  factory 
which  manufactures  a  single  commodity,  as 
cement,  beer,  etc.,  is  simple  compared  with 

11 


Fundamentals  of  Cost  and  Profit  Calculation 

the  problem  of  cost  determination  in  a  factory 
where  every  lot  is  different  from  every  other 
lot,  as  is  the  case  in  factories  making  goods  to 
order  upon  specifications  provided  by  the  cus- 
tomers, as  in  the  manufacture  of  metal  parts, 
stampings,  printing,  etc. 

Every  individual  expense  item  is  definite 
(i)  in  amount,  or  it  could  not  be  recorded; 
(2)  in  purpose,  otherwise  it  would  not  be  au- 
thorized; and  (3)  in  benefit,  for  it  is  to  pro- 
cure some  definite  thing,  either  a  commodity 
or  service,  more  desirable  than  the  amount  of 
money  involved,  that  the  expenditure  is  made. 

Expenses  may  be  classified  into  two  pri- 
mary groups:  Direct  expenses  and  Indirect 
expenses. 

Expense  items  which  have  but  one  bene- 
ficiary, to  which  they  are  chargeable  in  total, 
without  distribution,  are  direct  expenses. 

Expense  items  which  have  two  or  more 
beneficiaries,  requiring  distribution,  are  indi- 
rect expenses. 

These  divisions  have  long  bfeen  recognized 
by  cost  accountants,  but  someone,  generations 
ago,  thoughtlessly  assumed  that  more  or  less 
of  the  direct  expenses  might  safely  be  used  as 
a  basis  for  charging  the  indirect  expenses,  and 

12 


The  Philosophy  of  Cost  and  Profit 

later  generations  of  accountants  have,  with- 
out question,  accepted  the  formulae  as  au- 
thoritative. The  slightest  effort  in  the  direc- 
tion of  analysis  will  prove  that  no  expense  is 
basic,  and  that  such  methods  have  no  founda- 
tion in  fact. 

No  accountant  would  think  of  adding  to- 
gether the  direct  items  of  material  and  direct 
wages  on  a  hundred  orders  and  distributing 
the  total  to  the  individual  orders  upon  some 
arbitrary  and  unrelated  basis,  because,  being 
direct  expenses,  he  can  make  the  charge  to 
each  without  necessity  for  distribution.  Yet, 
for  many  decades,  since  the  introduction  of 
labor-saving  and  automatic  machinery,  the 
standard  practice  of  cost  accounting  has  been 
to  mass  the  unrelated  indirect  expenses  into  an 
"overhead"  or  "general  expense"  account  and 
distribute  the  total  upon  a  purely  arbitrary 
and  unrelated  basis,  as  for  example  the  direct 
labor  expense,  or  the  total  of  material  and 
direct  labor  expenses. 

As  no  expense  item  is  basic,  and  no  group 
of  expenses  is  basic,  such  methods  are  purely 
arbitrary  and  have  no  relation  to  facts. 

That  men  who  are  otherwise  intelligent 
will  advocate  and  follow  such  practices  is 
prima  facie  evidence  that  the  principle  of  ex- 

13 


Fundamentals  of  Cost  and  Profit  Calculation 

pense  distribution  is  unknown  to  them. 
Further,  it  is  proof  of  the  power  of  precedent 
to  so  enthrall  its  devotees  that  they  will  fol- 
low established  routine  long  after  progressive 
changes  ih  correlated  factors  have  made  such 
methods  ridiculous. 

As  the  result  of  analysis  it  is  found  that 
every  element  of  cost  is  related  directly  to 
certain  definite  processes  or  functions  of  the 
business;  that  where  division  of  benefits  re- 
quire distribution  of  the  expense  item,  the 
divided  parts  can  be  measured  and  propor- 
tions determined,  so  that  in  every  case  the 
charge  can  be  made  in  such  a  manner  that 
the  proportions  of  expense  charged  will  be 
identical  with  the  proportions  of  benefits  con- 
ferred. 

Cost  accounting  recognizes  no  principle 
of  expense  distribution,  but  depends  upon 
purely  arbitrary  methods.  It  uses  the  only 
method  possible  where  an  overhead  expense 
account  is  created.  The  creation  of  such  a 
mass  of  unrelated  expenses  in  itself  defeats  the 
possibility  of  correct  distribution  because  it 
combines  elements  requiring  different  kinds 
of  units  for  expressing  volume,  whereas  the 
practical  distribution  provided  in  cost  engi- 
neering requires  that  all  of  the  factors  of  a 

14 


The  Philosophy  of  Cost  and  Profit 

group  should  be  measurable  by  a  common 
unit 

Correct  expense  distribution,  then,  is  ac- 
complished by  considering  each  element  in 
relation  to  the  benefit  conferred,  combining 
the  elements  in  groups  only  when  the  factors 
of  the  group  consist  of  items  providing  iden- 
tical proportions  of  benefits,  all  of  which  are 
measurable  by  a  common  unit. 

In  succeeding  chapters  the  various  classi- 
fications of  expenses  will  be  considered,  the 
principle  of  expense  distribution  presented 
and  explained,  and  methods  of  determining 
the  cost  of  articles  or  items  outlined. 

Hazy  as  is  the  definition  of  cost  to  the 
average  man,  it  is  little  if  any  less  understood 
than  the  word  ^Trofit." 

Profit  is  that  part  of  the  ^^price'^  for  which 
an  article  is  sold  which  remains  after  the  cost 
has  been  deducted. 

Percentages  of  profit  are  correctly  ex- 
pressed only  when  they  relate  to  the  selling 
price  as  the  base,  or  ioo%. 

The  profits  of  a  period  are  expressed  in 
relation  to  the  total  of  sales. 

Statements,  frequently  seen  in  the  public 
prints,    which    assert   that    ioo%    or    200% 

15 


Fundamentals  of  Cost  and  Profit  Calculation 

profit,  or  other  percentages  above  loo,  were 
or  can  be  made  on  the  sale  of  goods,  simply 
display  the  ignorance  of  the  person  responsi- 
ble for  the  statement. 

If  an  article  costing  one  cent  is  sold  for 
one  dollar  the  profit  percentage  would  be  99. 
It  is  inconceivable  that  100%  profit  could  be 
made  on  a  transaction,  for  such  a  condition 
would  exist  only  in  case  the  goods  sold  cost 
nothing,  and  no  expense,  even  that  of  time, 
was  involved  in  the  conduct  of  the  business. 

A  very  common  but  erroneous  method  of 
calculation  is  to  compare  the  profits  with  the 
investment,  expressing  the  relation  by  per- 
centage. 

Such  errors  and  the  consequent  confusion 
are  due  to  the  fact  that  the  accounting  pro- 
fession has  no  definite  terminology.  An  effort 
to  establish  a  correct  terminology  in  connec- 
tion with  the  science  of  Cost  Engineering  was 
made  by  the  author  several  years  ago  in  "A 
Catechism  of  Costfinding"  now  practically 
out  of  print.  A  similar  effort  is  included  in 
this  book  under  "The  Terminology  of  Cost 
Engineering." 

No  scheme  of  figuring  profits  can  be  con- 
sidered practical  which  does  not  include  in 

16 


The  Philosophy  of  Cost  and  Profit 

cost  every  element  chargeable  either  immedi- 
ately or  eventually  as  an  expense  item. 

Profit  is  always  the  net  increase  in  tangi- 
ble assets  due  to  the  active  transactions,  or 
sales,  of  business.  It  has  no  relation  to  invest- 
ment. 

Interest  on  investment  is  not  profit,  but  is 
the  wage  of  financial  energy.  It  is  a  form  of 
fixed  expense  that  has  no  relation  to  activity 

or  the  transactions  of  business. 

« 

Increased  value  of  merchandise,  due  to 
fluctuations  in  price,  is  not  a  part  of  profits. 
The  actual  sale  of  the  goods  at  a  higher  price, 
because  of  the  market  fluctuation,  will  un- 
doubtedly yield  a  larger  margin  of  profit,  but 
the  profit  cannot  exist  until  the  sale  is  actually 
made. 

The  anticipation  of  profits,  because  of 
market  changes  or  the  carrying  of  goods  in  a 
warehouse  at  a  valuation  which  is  higher  than 
their  cost,  and  thereby  anticipating  profits,  is 
never  justifiable. 

No  profit  exists  until  the  transaction  has 
been  carried  forward  at  least  to  the  point 
where  the  recorded  charge  for  the  item  sold 
exceeds  the  total  of  the  outlay  for  the  item 
and  the  expenses  of  conducting  the  business. 

17 


Fundamentals  of  Cost  and  Profit  Calculation 

Gross  profit  is  a  myth.  The  term  was  origi- 
nated and  is  used  to  designate  a  percentage 
applied  to  part  of  the  elements  of  cost  for  the 
purpose  of  arriving  at  a<supposedly  profitable 
selling  price  in  which  neither  the  cost  nor  the 
amount  of  profit  is  definitely  known.  It  is  a 
makeshift  term,  practicable  only  as  a  means 
of  avoiding  an  admission  of  ignorance  of  true 
cost. 

Further  discussion  of  "Profits"  will  be  in- 
cluded in  the  chapter  entitled  "Selling  Prices 
and  Profits." 


18 


CHAPTER  TWO 

DIRECT  EXPENSES 

Direct  Expenses  are  few  in  number,  com- 
pared to  Indirect  Expenses,  and  present  prac- 
tically no  problem  to  either  the  accountant  or 
the  Cost  Engineer. 

A  direct  expense  item  is  one  expended 
for  the  benefit  of  but  one  beneficiary. 

It  may  be  chargeable  to  an  individual  fac- 
tory order,  an  individual  manufacturing 
process,  a  class  of  product,  or,  in  the  case  of 
an  office  or  store,  it  may  be  chargeable  to  an 
order,  a  department  or  a  class  of  merchandise. 

A  direct  expense  item  is  always  charge- 
able in  total  to  a  single  account  or  beneficiary. 
It  never  presents  a  problem  in  expense  dis- 
tribution because  its  benefit  is  never  divided. 

The  major  direct  expense  items  are  the 
material  chargeable  to  a  factory  order  and 
the  amount  of  wages  paid  to  workers  engaged 
in  production  on  individual  factory  orders. 

The  minor  direct  expenses  are,  repairs  to 
machinery,  which  should  be  charged  directly 
to  the  process  for  which  the  machine  is  re- 
quired; the  supplies  required  for  processes; 

19 


Fundamentals  of  Cost  and  Profit  Calculation 

indirect  wages  for  service  in  connection  with 
an  individual  process;  the  cost  of  replacing 
spoiled  material  or  ^product;  expense  for 
sharpening  tools,  or  replacing  points  and 
knives  worn  out  or  destroyed  in  the  operation 
of  processes;  freight  or  cartage  on  shipments 
which  require  such  expense  in  excess  of  the 
usual  cost  of  delivery;  advertising  used  in 
connection  with  special  lines  of  product,  etc. 

Many  items  which  are  direct  in  relation 
to  a  process  are  indirect  in  relation  to  the  fac- 
tory order.  In  determining  classifications  the 
relationship  must  be  considered. 

Early  in  the  history  of  the  race  each  in- 
dividual or  family  existed  upon  the  product 
of  its  own  energy,  but  when  the  advantages  of 
specialization  became  apparent,  men  began 
specializing  in  the  things  that  they  could  do 
best,  and  serving  their  neighbors,  who  in  turn 
selected  other  special  work,  so  that  exchange 
of  product  took  place,  and  there  was  devel- 
oped what  we  now  call  ^^trade." 

One  man  made  shoes,  another  clothes,  an- 
other built  houses,  thus  originated  the  shoe- 
makers, the  tailors  and  the  building  trades. 
As  the  demand  became  greater  than  the  indi- 
vidual worker  could  supply  he  took  on  as 

20 


Direct  Expenses 


helpers  other  individuals  to  whom  he  taught 
the  "trade,"  and  thus  he  became  an  employer. 

Rivalry  sprang  up  between  the  workmen, 
each  striving  to  do  his  work  more  skillfully 
than  his  fellows.  Since  the  quality  of  the  out- 
put and  speed  of  production  depended  largely 
upon  the  condition  of  the  tools  used,  the  care- 
ful workmen  found  it  most  practical  to  pro- 
vide their  own  equipment,  thus  avoiding 
exchanges  with  careless  workmen  which 
might  occur  if  the  tools  were  owned  by  the 
employer,  and  the  rights  of  usage  common 
between  them. 

In  those  days  there  were  no  power-driven 
machine  tools  requiring  heavy  investment  on 
the  part  of  the  employer.  Neither  power, 
repairs  nor  machine  supplies  were  necessary. 
Consequently,  the  major  items  of  expense 
were  for  materials  and  the  wages  of  the  work- 
men. 

Product  was  comparatively  uniform  in 
character.  No  such  factory  organizations 
existed  as  are  common  today.  It  was  both  pos- 
sible and  practicable  for  the  employer  to  de- 
termine a  selling  price  by  calculating  the 
amount  of  the  outlay  for  material  and  wages 
applying  a  percentage  margin  sufficient  to 

21 


Fundamentals  of  Cost  and  Profit  Calculation 

cover  his  few  other  factory  expenses,  his  liv- 
ing, and  a  fair  profit. 

To  make  the  employer's  problem  easier, 
the  absence  of  transportation  facilities  in 
those  days  limited  competition  to  his  imme- 
diate locality.  No  salesmen  were  calling  on 
his  customers  with  similar  goods  at  lower 
prices  as  is  the  case  today.  In  fact,  if  his  was 
the  only  shop  in  the  neighborhood  engaged 
in  his  particular  line  he  had  a  virtual  mo- 
nopoly, and  the  price  obtainable  was  limited 
only  by  the  keenness  of  the  demand  and  the 
ability  of  his  customers  to  pay. 

Changes  in  methods  took  place  gradually. 
Labor-saving  machines  were  introduced,  mak- 
ing it  possible  for  one  man  to  produce  many 
times  as  much  product  in  a  given  time  as  for- 
merly. Wage  rates  remained  practically  the 
same  per  day  as  before,  and  the  employer  as- 
sumed that  he  was  getting  several  times  as 
much  product  as  previously  with  the  same 
expense. 

Expenses  for  power,  repairs,  supplies,  etc., 
were  charged  to  general  expense,  or  overhead. 
Little  or  no  consideration  was  given  to  depre- 
ciation, or  interest  on  investment.  Everything 
except  material  and  direct  wages  was  charged 
to  overhead,  the  total  of  which  was  distrib- 

22 


Direct  Expenses 


uted  to  orders  or  lots  on  the  basis  of  '^prime 
cost,"  the  total  of  material  and  direct  wages 
involved. 

Gradually  manufacturers  learned  that  the 
expenses  of  processes  had  no  relation  to  the 
cost  of  the  materials;  that  it  cost  no  more  to 
cut  or  sew  goods  costing  $6.00  per  yard  than 
to  do  the  same  work  with  goods  that  cost  half 
as  much.  The  cost  of  operating  a  stamping 
press  was  the  same  whether  the  material  being 
formed  was  iron  or  brass.  By  many  manu- 
facturers, material  was  dropped  from  con- 
sideration as  a  basic  item,  and  direct  wages 
alone  adopted  as  the  basis  of  distribution. 

The  automatic  machine  has  all  but  elim- 
inated the  wage  factor  on  many  processes.  In 
many  factories  the  variety  of  processes  ranges 
from  hand  work,  done  in  the  original  way 
with  bench  and  hand  tools,  through  varying 
processes  involving  high  wage  rates  and  small 
investments,  low  wage  rates  and  large  invest- 
ment, to  the  extreme  where  one  individual 
attends  several  machines.  Yet  the  traditional 
practice  of  assuming  that  wages  are  basic  re- 
mains the  most  commonly  used  method  of 
distributing  the  indirectexpenses. 

In  hundreds  of  instances  throughout  the 
country,  both  material  and  wages  are  so  con- 

23 


Fundamentals  of  Cost  and  Profit  Calculation 

sidered.  Ridiculous  though  they  are,  prac- 
tically all  schools  of  post  accounting  still 
teach  these  methods.  Leading  "authorities" 
on  cost  accounting,  in  current  publications, 
cite  them  as  having  certain  advantages,  giving 
simplicity  precedence  over  accuracy. 

Let  us  test  their  merit: 

The  most  important  of  the  indirect  ex- 
penses are  for  housing,  or  rent  for  the  space 
used;  equipment,  involving  depreciation, 
taxes,  insurance,  etc. ;  power,  and  administra- 
tion. 

Suppose  that  in  a  given  factory  two  men 
are  employed,  one  at  a  wage  of  25  cents,  and 
the  other  at  50  cents  per  hour. 

If  there  is  a  relation  between  the  amount 
of  wages  paid  to  the  workman,,  and  the  other 
expenses,  the  amount  of  space  used  by  the  50- 
cent  man  must  be  double  that  used  by  the  25- 
cent  man.  The  same  proportion  should  exist 
in  the  equipment  investment,  in  the  amount  of 
power  used,  and  it  should  require  twice  as 
much  effort  to  supervise,  and  keep  the  records 
of  the  50-cent  man's  time,  as  to  do  the  same 
work  for  the  25-cent  man. 

The  facts  are,  that  as  between  the  wages 
paid  to  the  workers  and  the  indirect  expenses, 

24  f 


Direct  Expenses 


no  such  relation  exists.  Careful  analyses  made 
by  competent  and  experienced  cost  engineers 
of  the  individual  expense  items  involved  in 
the  operation  of  over  six  hundred  factories 
have  failed  to  disclose  a  single  instance  where 
any  other  expense  was  in  the  same  proportion, 
or  had  any  discernible  relation  to  the  amount 
of  direct  wages  paid  to  the  workers. 

In  fact  it  has  been  thoroughly  demon- 
strated that  there  is  no  single  expense  item 
nor  group  of  items  which  is  ba^sic,  or  that  can 
be  safely  used  as  a  basis  for  the  distribution 
of  another  expense  item,  or  group  of  expenses. 

The  author  has  been  told  many  times  by 
manufacturers  that  they  had  no  problem  of 
costfinding  because  they  paid  their  workers 
by  the  "piece."  Experience  proves  that  the 
piecework  wage  system  complicates,  rather 
than  simplifies,  the  work  of  the  cost  engineer. 

The  assumption  of  the  majority  of  manu- 
facturers who  pay  wages  by  pieces,  is  that 
because  the  material  cost  is  the  same,  and  the 
wages  per  piece  the  same,  all  like  pieces  cost 
the  same,  regardless  of  the  speed  or  skill  of 
the  workers.    Let  us  see. 

Suppose  two  workers  are  engaged  on  the 
same  kind  of  process,  using  the  same  equip- 

25 


Fundamentals  of  Cost  and  Profit  Calculation 

ment,  supplies,  power,  etc.,  and  supervised 
by  the  same  foreman.  Ohe,  however,  pro- 
duces loo  pieces  per  day  and  receives  as  pay 
therefor  $1.50.  The  other  produces  200 
pieces  per  day  and  receives  as  pay  $3.00.  Such 
cases  are  common  in  actual  experience. 

Assume  also  that  the  overhead  percentage 
as  determined  by  the  cost  accountant  is  100% 
(a  rate  in  common  use  regardless  of  the  true 
proportion  of  the  "overhead  burden"  to  the 
total  of  the  direct  payroll).  Adding  100% 
to  the  wages  paid  we  find  that  the  result  makes 
it  appear  that  the  lOO-piece  lot  cost  $3.00,  the 
200-piece  lot  cost  $6.00,  and  the  per  piece  cost 
is  the  same  in  both  lots.    What  are  the  facts? 

The  worker  who  earned  $1.50  required 
the  same  equipment  investment  as  the  other, 
used  the  same  amount  of  space,  the  same 
amount  of  power,  the  same  supervision.  In 
fact  all  the  elements  were  identical,  except 
the  wages ;  so  that  the  actual  difference  in 
cost  of  the  two  lots  was  not  $3.00,  as  the  ac- 
countant figured,  but  $1.50.  Assuming  now 
that  the  total  of  the  indirect  expenses  applied 
was  correct,  an  equal  division  would  show 
$2.25  applicable  to  each.  The  cost  of  the 
loo-piece  lot  is  now  found  to  be  $3.75,  and 
the  200-piece  lot  cost  $5.25,  or  $2.62^  per  hun- 

26 


Direct  Expenses 


dred.  The  product  of  the  low  wages  is  found 
to  be  the  most  expensive,  while  that  of  the 
employe  receiving  higher  wages  because  of 
greater  efficiency  is  nearly  one-third  less  ex- 
pensive per  piece. 

Experience  and  analysis  prove  that  no  ex- 
pense is  basic,  that  all  efforts  to  use  direct 
wages  or  other  direct  expenses  as  a  means  of 
apportioning  the  indirect  expenses  are  mis- 
leading. 

We  find  that  while  methods  of  manufac- 
ture have  been  constantly  improved  until  me- 
chanical processes  have  almost  universally 
displaced  manual  methods,  the  accounting 
profession  has  failed  to  keep  pace  with  the 
improvements.  Its  ^^authorities"  are  still  ad- 
vocating and  teaching  methods  rendered 
obsolete  by  the  introduction  of  the  first  labor- 
saving  machine  tool,  and  are  becoming  more 
and  more  inadequate  and  ridiculous  with 
every  progressive  step  in  mechanical  processes 
of  production. 

It  is  time  that  manufacturers  everywhere 
learned  to  think  for  themselves,  to  discard 
obsolete  and  misleading  methods,  and  demand 
others  which,  in  the  light  of  modern  scientific 
analysis,  can  be  depended  upon  to  show  the 

27 


Fundamentals  of  Cost  and  Profit  Calculation 

true  relation  between  cost  and  selling  price 
in  every  transaction. 

Direct  expenses  are  not  basic  cost  factors. 
They  are  simply  expense  factors  which,  hav- 
ing but  a  single  beneficiary,  require  no  act  of 
distribution. 


28 


CHAPTER  THREE 

INDIRECT  EXPENSES 

In  all  the  history  of  trade,  commerce,  and 
manufacture  the  indirect  expenses  of  business 
present  the  problem  hardest  of  solution. 

A  brief  statement  of  the  early  history  of 
this  subject  was  included  in  the  preceding 
chapter.  Only  that  phase  of  the  subject  was 
covered,  however,  relating  to  the  use  of  direct 
expenses  as  a  basis  of  distribution. 

In  a  comparatively  few  instances,  an  effort 
has  been  made  in  plants  having  a  number  of 
departments  doing  different  kinds  of  work, 
to  treat  each  department  as  though  it  were  a 
separate  factory.  Thus  in  a  factory  manu- 
facturing agricultural  implements  depart- 
mental divisions  would  be  formed  for  foun- 
dry, forging,  machine  shop,  woodwork,  paint- 
ing, etc. 

An  effort  was  made  thereby  to  charge 
directly  to  the  department  as  far  as  the  ac- 
countant was  able,  such  expenses  as  seemed 
to  belong  to  each.  The  general  expenses  of 
the  business  were  then  charged  throughout 
either  upon  the  basis  of  the  direct  wage  pay- 
roll of  departments  or  as  in  a  few  cases,  in 
the  ratio  of  the  totals  of  the  expenses  directly 
charged.    The  total  of  these  so  called  "depart- 

29 


Fundamentals  of  Cost  and  Profit  Calculation 

4. 

mental  overheads"  was  distributed  over  the 
factory  orders  in  proportion  to  the  direct 
wages  involved,  or  in  proportion  to  the  man 
hours  of  the  workmen  engaged  directly  upon 
the  orders. 

In  simple  factories,  corresponding  to  the 
individual  departments  of  the  composite  fac- 
tory, the  man  hour  basis  is  sometimes  used  by 
accountants. 

Another  method  of  distributing  the  in- 
direct expenses  in  factories  employing  a  vari- 
ety of  labor,  as  well  as  a  wide  range  of  invest- 
ment in  machinery  for  different  processes,  is 
the  "machine  hour  rate"  plan. 

This  plan  takes  into  consideration  more  or 
less  crudely  the  expenses  involved  on  account 
of  the  different  amounts  of  investment,  the 
varying  rates  of  depreciation,  the  power 
required,  the  floor  area  occupied,  etc.,  and 
divides  the  total  by  the  number  of  hours  that 
the  management  estimates  the  machine  should 
be  operated  normally  during  a  given  period, 
usually  a  year. 

The  rate,  thus  determined,  is  added  to  the 
direct  wages  of  the  workers  on  each  process, 
and  to  the  sum  of  them  is  added  the  expenses 
of  administration  on  some  arbitrary  basis, 
usually  the  total  of  the  "prime  cost"  of  the 
order. 

30 


Indirect  Expenses 


Early  in  the  present  century  Mr.  A.  Ham- 
ilton Church,  an  engineer,  in  his  book  ^^Dis- 
tribution of  the  Expense  Burden,"  offered  a 
progressive  step  by  suggesting  that  a  factory 
be  divided  into  units,  each  of  which  per- 
formed a  single  type  of  operation.  Each  of 
these  divisions  was  to  be  treated  as  though  it 
was  a  separate  factory,  although  under  the 
same  roof,  and  no  dividing  partitions  existed. 

Under  his  plan  every  division  should  be 
charged  with  its  rent  upon  the  basis  of  floor 
area.  Depreciation,  insurance  on  equipment, 
and  taxes,  should  be  charged  upon  the  basis 
of  investment,  while  power  was  to  be  charged 
on  the  basis  of  horsepower  hours.  An  hourly 
rate  was  then  determined  by  dividing  the  total 
by  the  actual  productive  hours.  This  imme- 
diately appealed  to  practical  men  as  being 
a  sound  and  logical  method  of  handling  these 
expenses. 

Thus  far  Church  solved  the  problem  of 
expense  distribution  satisfactorily,  but  his 
work  was  incomplete,  for  in  the  same  book  he 
admitted  that  the  problem  of  distributing  the 
administration  expense  or,  as  he  termed  them, 
the  ^'general  establishment  charges,"  baffled 
him.  He  vigorously  attacked  the  traditional 
method  of  charging  them  on  the  basis  of  direct 
wages,  and  doubted  the  practicability  of  pro- 

31 


Fundamentals  of  Cost  and  Profit  Calculation 

ductive  hours  as  a  universal  basis,  therefore 
admitting  that  he  could  offer  no  satisfactory 
rule  for  their  distribution,  he  put  the  problem 
up  to  the  reader,  advising  him  to  use  his  own 
judgment  as  to  the  method  most  practical  for 
any  individual  case. 

Church's  effort  should  have  recognition 
as  the  first  radical  step  away  from  the  tra- 
ditional formulas  of  cost  accounting,  and  in 
the  direction  of  what  is  today  known  as  Cost 
Engineering. 

All  the  definite  suggestions  made  by  him 
conform  to  the  fundamental  principle  of  ex- 
pense distribution,  the  very  foundation  of  Cost 
Engineering.  Had  he  gone  a  little  farther, 
and  analyzed  his  own  methods,  he  would  have 
found  that  in  each  case  the  expense  was 
charged  in  proportion  to  the  advantage  it  con- 
ferred on  the  benefited  divisions,  and  that 
those  proportions  were  always  expressed  in 
the  term  of  measure  denoting  the  relative  vol- 
ume of  the  units.  For  example,  the  item  of 
rent  being  expended  to  secure  usable  floor  area 
benefited  each  division  in  the  proportion  of 
the  floor  area  used.  Floor  area  is  logically 
measured  by  using  the  square  foot  as  a  unit; 
therefore  the  relative  number  of  square  feet  of 
area  used  indicated  the  relative  amount  of 
expense  chargeable. 

32 


Indirect  Expenses 


In  like  manner,  since  it  is  the  dollars  of 
investment  which  must  be  protected  against 
loss  through  depreciation  of  machinery;  and 
against  fire  by  insurance;  and  against  which 
taxes  are  levied;  the  dollars  of  investment  in 
the  various  divisions  indicate  the  proportions 
of  depreciation,  insurance  and  tax  expenses 
chargeable  to  each. 

In  1908,  when  the  author  developed  and 
formulated  the  fundamental  principle  of  ex- 
pense distribution  he  had  not  heard  of  Mr. 
Church,  nor  of  his  book,  but  he  had  come  into 
contact  with  the  methods  which  he  advocated, 
and  they  seemed  so  logical  that  he  immedi- 
ately analyzed  them  to  determine  the  princi- 
ple behind  them. 

Through  long  experience,  and  by  careful 
analysis,  it  has  been  found  that  the  principle, 
as  formulated,  applies  to  every  known  indi- 
rect expense,  and  is  therefore  accepted  as 
fundamental.  This  principle  and  its  method 
of  application  will  be  presented  at  length  as 
the  author  proceeds. 

An  indirect  expense  item  is  one  which, 
having  two  or  more  beneficiaries,  requires 
distribution. 

The  reason  that  distribution  of  indirect  ex- 
penses has  baffled  the  accounting  profession  so 
long  is  that  in  the  absence  of  knowledge  of  the 

33 


Fundamentals  of  Cost  and  Profit  Calculation 

fundamental  principles  of  expense,  they  per- 
sisted in  grouping  unrelated  expenses  into 
masses,  thereby  destroying  the  possibility  of 
correct  distribution. 

Every  expense  item  is  originally  definite 
in  amount,  purpose  or  object,  and  benefit. 
The  difference  between  direct  and  indirect 
expenses  is  that  whereas  the  direct  expense 
item  has  a  single  beneficiary  to  which  it  may 
be  charged  in  total,  the  indirect  expense  has 
two  or  more  beneficiaries  between  which  it 
must  be  distributed,  or  charged,  in  propor- 
tion to  the  benefits  conferred. 

The  human  mind  cannot  conceive  of  a 
divisible  thing  that  cannot  be  measured  by 
some  unit  of  weight,  measure  or  count. 
Therefore  it  follows  that  if  the  benefit  con- 
ferred by  a  certain  expense  item  is  divisible, 
it  is  also  measurable.  Being  measurable,  the 
relative  proportions  are  easily  expressed  and 
may  be  used  as  a  guide  for  charging  the  money 
expended. 

One  of  the  weaknesses  of  the  accountants' 
efforts  seems  to  be  a  penchant  for  expressing 
all  proportions  in  percentages.  In  the  dis- 
tribution of  expenses  of  manufacture,  percent- 
ages are  not  only  unnecessary  but  cumber- 
some. Proportions  and  not  percentages  are 
important. 

34 


Indirect  Expenses 


While  individual  indirect  expense  items 
are  easily  distributed,  economy  of  time  and 
effort  is  desirable.  Therefore  it  is  advisable 
to  group  expenses  for  simultaneous  distribu- 
tion wherever  such  grouping  is  practicable. 

Indirect  expenses  may  be  grouped  for 
simultaneous  distribution  only  when  their 
benefits  are  measurable  by  a  common  unit,  and 
their  beneficiaries  participate  in  identical 
ratios. 

The  inclusion  of  two  or  more  unrelated  in- 
direct expense  items  in  a  single  account  or 
group,  as  "overhead,"  "burden,"  or  "general 
expense,"  obscures  the  purposes  of  the  ex- 
penditures and  renders  correct  distribution 
impossible. 

Lacking  knowledge  of  the  principles  of 
expense  grouping,  accountants  and  others  have 
charged  part  of  the  expenses  individually  ac- 
cording to  the  best  information  which  they 
had,  and  combined  the  remainder  in  an  over- 
head expense  account  for  distribution  upon 
some  more  or  less  arbitrary  basis. 

Thus  it  will  be  seen  that  the  extent  of  the 
overhead  or  burden  account  in  any  cost  sys- 
tem reveals  the  extent  to  which  the  account- 
ant is  ignorant  of  the  principles  of  expense 
grouping  and  expense  distribution. 

Where  these  principles  are  understood  and 
35 


Fundamentals  of  Cost  and  Profit  Calculation 

intelligently  applied,  it  will  be  found  that 
there  is  not  left  a  single  undistributed  item  to 
apply  arbitrarily.  In  fact,  if  there  were  a 
single  instance  in  experience  where  the  prin- 
ciple did  not  apply  clearly,  it  would  be  posi- 
tive proof  that  the  statement  of  the  principle 
was  wrong.  Then  we  would  immediately 
have  to  search  again  for  the  fundamental  truth 
which  would  cover  every  requirement. 

For  ten  years  the  author  has  discussed  this 
subject  with  thousands  of  manufacturers  and 
supervised  the  application  of  these  principles 
in  hundreds  of  factories.  Not  a  single  instance 
has  he  found  where  these  principles,  and  the 
others,  which  all  together  form  the  funda- 
mental principles  of  Cost  Engineering,  did 
not  fully  measure  up  to  all  requirements. 

This  experience,  and  the  excellent  results 
attained  through  it,  must  convince  the  most 
skeptical  that  Cost  Engineering  actually  ac- 
complishes all  that  cost  accounting  aimed  to 
do  but  failed;  that  Cost  Engineering  is  a  prac- 
tical science,  and  that  its  principles  are  as 
fundamental,  teachable  and  universal  in  appli- 
cation as  the  axioms  of  mathematics. 

Fundamental  principles  are  invariable. 
Rules  may  be  made  for  applying  the  princi- 
ples, but  whenever  the  facts  in  any  case  are 
such  that  the  strict  application  of  the  rule 

36 


Indirect  Expenses 


will  conflict  with  the  principle,  the  principle 
must  govern  and  the  rule  be  changed  to  meet 
the  condition.    For  example: 

In  a  factory  occupying  a  building  by  itself, 
or  a  part  of  a  building  where  the  type  of  con- 
struction is  uniform  throughout,  the  arrange- 
ment of  equipment  purely  arbitrary  with  the 
management,  and  uniform  temperature  re- 
quired throughout,  the  elements  of  rent  and 
heat  can  be  combined.  The  total  of  this  group 
may  then  be  distributed  to  the  factory  divi- 
sions upon  the  basis  of  floor  area. 

But  if  certain  processes  require  a  special 
type  of  construction,  different  from  the  rest, 
so  that  the  arrangement  is  dependent  upon 
such  construction,  or  if  the  atmosphere  of  cer- 
tain rooms  must  be  maintained  at  different 
temperatures  because  of  the  requirements  of 
the  processes  performed  therein,  then  they 
cannot  be  combined.  Such  conditions  cause 
the  rule  to  conflict  with  the  principle  that  the 
beneficiaries  must  participate  in  identical 
ratios. 

Under  such  conditions  the  items  of  rent 
and  heat  should  be  distributed  separately  in 
order  that  due  consideration  may  be  given  to 
the  variation  in  requirements,  and  each  divi- 
sion be  charged  with  these  elements  in  the 
exact  ratio  of  benefits  conferred. 

37 


Fundamentals  of  Cost  and  Profit  Calculation 

Indirect  expenses  are  of  two  types  and  may 
be  classified  as  ^^mmediate,"  and  "ultimate," 
or  economic. 

Immediate  indirect  expenses  are  items 
usually  appearing  on  the  books,  as  a  matter  of 
record,  immediately  upon  their  being  in- 
curred. 

These  are  represented  by  the  following  by 
no  means  complete  list: 

Rent,  fuel,  current  or  gas  for  lighting, 
power,  insurance,  supplies,  salaries,  repairs, 
taxes,  telephone,  telegraph,  postage,  wages, 
compensation  insurance,  etc. 

Ultimate  indirect  expenses  are  items  that 
are  not  usually  considered  and  recorded  at 
the  time  that  they  are  incurred,  but  are  very 
generally  left  for  consideration  at  the  end  of 
the  fiscal  year,  if  at  all. 

Some  managers  hold  that  consideration  of 
these  items  is  optional  with  them,  and  they 
are  all  too  frequently  left  entirely  out  of  state- 
ments. 

Some  accountants,  fearful  that  they  will 
incur  the  displeasure  of  the  client  if  they  show 
that  the  business  is  not  profitable,  omit  at  least 
a  part  of  the  items,  creating  the  impression 
that  the  business  is  more  profitable  than  is 
really  the  case. 


Indirect  Expenses 


Some  managers,  especially  those  who  have 
no  interest  in  a  business  beyond  their  "jobs," 
insist  that  important  items  be  omitted,  in  order 
that  the  business  may  show  a  profitable  result 
when  no  real  profit  exists. 

Some  accountants  and  many  managers  for 
selfish  reasons  assume  that  the  inclusion  of  in- 
terest on  investment  is  a  mooted  question,  and 
argue  against  it  because  it  is  to  their  personal 
interest  to  do  so. 

The  accounting  profession  as  a  rule  holds 
out  against  the  inclusion  of  interest  except  that 
paid  for  borrowed  money.  Within  recent 
years,  however,  the  number  of  accountants 
who  admit  the  justice  of  interest  charges  on  all 
of  the  investment  has  been  on  the  increase. 

One  unfortunate  phase  of  the  situation  is 
that  the  profession  has  made  no  noticeable 
effort  to  reach  a  just  and  final  conclusion  in 
this  matter.  If  it  was  taken  up  for  formal 
consideration,  it  is  not  likely  that  even  though 
convinced  of  the  justice  of  including  interest 
charges,  any  considerable  number  of  those 
who  have  held  out  against  it  would  admit  a 
change  of  viewpoint. 

A  typical  instance  of  the  attitude  of  the 
older  generation  of  accountants  is  shown  in 
the  following  incident  in  which  the  author 
was  a  principal  participant:    A  manufacturer 

39 


Fundamentals  of  Cost  and  Profit  Calculation 

who  had  given  an  order  for  the  installation  of 
a  cost  accounting  system  to  an  old  friend  who 
was  a  C.  P.  A.  called  upon  the  author  to  clear 
up  some  interesting  points  of  difference  be- 
tween cost  accounting  and  cost  engineering 
methods.  The  C.  P.  A.  was  present,  and  ad- 
mitted the  soundness  of  every  contention 
made,  but  would  not  yield  the  point  that  Cost 
Enginering  as  a  whole  was  more  practical  and 
accurate  than  the  so-called  "standard  account- 
ing practice"  represented  in  his  system.  He 
gave  as  his  reason  his  belief  that  he  could  not 
afford  to  brave  the  criticisms  of  the  profession 
should  it  become  known  that  he  had  made  a 
concession. 

Such  is  the  power  of  established  precedent 
to  hinder  progressive  development. 

The  manufacturer,  keenly  appreciating  the 
value  of  the  differences  brought  out  in  the  dis- 
cussion, and  the  narrowness  of  the  account- 
ant's viewpoint,  placed  his  order  at  once  for 
the  installation  of  a  Cost  Engineering  System 
to  replace  that  only  recently  installed  by  the 
C.  P.  A. 

A  discussion  of  the  author's  reasons  for  ad- 
vocating the  inclusion  of  interest  on  all  invest- 
ment, and  other  "ultimate  expenses,"  will  be 
covered  in  the  succeeding  chapter,  entitled 
"Economic  Expenses." 

40 


CHAPTER  FOUR 

ECONOMIC  EXPENSES 

Comparatively  few  manufacturers  and 
merchants  realize  as  they  should  the  impor- 
tant truth  that  assets  naturally  tend  to  shrink, 
while  liabilities  always  tend  to  increase  under 
indifference  or  neglect. 

Wealth  is  not  created  by  accident.  It  is 
created  by  the  expenditure  of  energy.  Some 
men  may  seem  to,  and  a  few  actually  do,  grow 
rich  without  expending  personal  energy,  but 
somewhere  in  the  background  unseen  forces 
are  at  work  involving  the  application  of  a 
form  of  energy. 

Energy  in  industry  is  of  three  kinds:  the 
personal  energy  of  the  individual  or  the  or- 
ganization; the  mechanical  energy  or  power 
applied  to  the  mechanical  equipment;  and  the 
financial  energy,  without  which  the  personal 
energy  and  mechanical  energy  would  be  com- 
paratively weak. 

Finances  are  the  lubricant  of  industry. 
Without  them  the  wheels  of  trade  and  com- 
merce must  cease  to  turn.  The  proof  of  this  is 
seen  in  the  thousands  of  failures  credited  to 
"lack  of  capital."  It  is  demonstrated  on  a  large 

41 


Fundamentals  of  Cost  and  Profit  Calculation 

scale  in  the  deep  valleys  of  trade  charts  mark- 
ing periods  of  financial  panic. 

When  the  purse  strings  of  the  nation 
tighten,  business  slows  down.  At  the  points 
where  the  greatest  strain  occurs  it  stops,  and 
failures  occur  in  large  numbers. 

These  three  kinds  of  energy  may  be  lik- 
ened to  the  supports  of  a  three-legged  stool. 
Remove  either  the  personal,  the  mechanical 
or  the  financial  energy,  and  the  structure  of  in- 
dustry topples. 

The  expenses  of  personal  energy  are  met 
in  salaries  and  wages  paid  to  workers.  The 
expenses  of  mechanical  energy  are  met  in  the 
expenditures  for  power  equipment  and  opera- 
tion, but  the  expenses  of  financial  energy,  the 
economic  or  "ultimate"  expenses,  being  less 
understood,  and  slower  in  exacting  the  penalty 
for  negligence,  are  most  often  neglected. 

Economic  expenses  are  the  charges,  or 
elements,  of  cost  which  must  be  included  to 
preserve  the  economic  balance,  or  equilibrium, 
of  capital.  They  counterbalance  deprecia- 
tion, waste,  shrinkage,  and  other  losses  due  to 
the  conditions  and  contingencies  of  business. 

If  they  are  neglected,  no  creditor  persist- 
ently requests  their  payment  and  no  attorney 

42 


Economic  Expenses 


calls  attention  to  the  fact  that  they  are  over- 
due, demanding  immediate  settlement,  yet  in 
the  end  they  must  be  paid. 

Because  they  are  not  payable  with  the  cur- 
rent bills  they  are  easily,  and  all  too  fre- 
quently, omitted  entirely  from  the  books  and 
financial  statements. 

Some  men  call  them  "intangible  expenses." 
Others  jest  about  them,  while  still  others  act 
on  the  assumption  that  their  recognition  is 
purely  optional  and  that  they  may  be  consid- 
ered in  prosperous  years,  and  omitted  in  the 
lean  years  of  business. 

They  are  sometimes  looked  upon  in  the 
same  light  as  voluntary  contributions  to  char- 
ity. Reference  to  them  is  almost  entirely 
omitted  from  the  curriculums  of  commercial 
schools.  Even  the  accounting  profession  has 
no  "standard  practice"  with  reference  to  them. 

They,  however,  have  been  brought  into 
their  proper  important  position  in  Cost  Engi- 
neering. For  it  is  the  business  of  the  Cost 
Engineer  to  analyze  and  present  the  facts  of 
business  as  they  exist,  not  as  the  client  would 
like  to  have  them  appear,  or  as  expediency 
demands,  in  order  that  a  financial  statement 
may  reflect  credit  upon  the  management. 

43 


Fundamentals  of  Cost  and  Profit  Calculation 

Accounts  payable  to  other  creditors  may 
be  defaulted  and  no  legal  action  follow; 
business  may  seem  to  prosper  in  spite  of  the 
neglect  of  these  elements,  but  ultimate  pay- 
ment cannot  be  sidestepped.  Time  is  the  in- 
exorable creditor,  exacting  payment  in  full  or 
foreclosing. 

Just  as  surely  as  the  natural  laws  govern- 
ing health  cannot  be  infringed  without  the 
penalty  of  illness,  violation  of  the  natural  law 
of  compensation  in  finance  will  result  in  loss, 
if  not  in  absolute  failure. 

Depreciation  is  not  an  expense. 

Notwithstanding  the  fact  that  the  account- 
ing profession  has  generally  advocated 
"charging  off"  at  the  end  of  the  year  "for  de- 
preciation" a  certain  amount  from  the  assets 
of  the  business,  depreciation  is  not  an  expense. 

Depreciation  is  a  contingency. 

The  custom  in  times  past  has  been,  and  still 
is,  to  think  of  depreciation  in  relation  to  "wear 
and  tear,"  the  physical  condition  only  being 
considered  in  calculations  as  to  the  life  of 
equipment. 

There  are  many  causes  of  depreciation,  but 
three  appear  more  prominently  than  others. 

44 


Economic  Expenses 


They  are  obsolescence,  inutility,  and  wear  and 
tear.    The  least  of  these  is  wear  and  tear. 

A  machine  may  be  in  first-class  physical 
condition  and  be  actually  a  liability  because 
it  is  out  of  date  and  its  operation  so  unprofit- 
able in  competition  with  modern  equipment 
as  to  create  a  loss. 

A  machine  may  be  in  perfect  physical  con- 
dition, and  up  to  date,  but  if  the  demand  for 
its  product  has  ceased,  so  that  it  cannot  be 
profitably  utilized,  it  becomes  a  liability 
rather  than  an  asset. 

If  the  machine  is  actually  worn  out  in 
service,  and  its  product  has  been  intelligently 
priced  and  sold,  a  reserve  has  been  provided 
thereby  for  its  replacement,  and  neither  loss 
nor  liability  is  created. 

Depreciation  is  a  contingency  which  the 
intelligent  manager  will  foresee  and  provide 
for  by  creating  a  reserve  for  replacement  (not 
by  the  makeshift  of  a  depreciation  account) . 

Replacement  reserve  is  provided  to  take 
care  of  the  probability  that  it  will  be  neces- 
sary at  the  end  of  an  estimated  period  to  pur- 
chase a  new  machine  to  replace  the  old.  Even 
though  no  machine  is  actually  purchased,  the 
reserve  should  be  provided  that  the  stockhold- 

45 


Fundamentals  of  Cost  and  Profit  Calculation 

ers  may  have  their  money  returned  to  them 
at  the  end  of  the  term  of  usefulness  of  the 
machine.  Capital  must  be  protected  against 
loss  if  financial  equilibrium  is  to  be  main- 
tained. 

"Charging  off"  for  depreciation  is  an  im- 
practical plan.  It  creates  a  constantly  reduc- 
ing basis  for  the  charge,  with  the  result  of 
lengthening  the  period  during  which  the 
charge  must  be  continued  to  balance  the  orig- 
inal investment.  Calculations  show  that  a  ten 
per  cent  per  annum  depreciation  charge  from 
reduced  bases  will  actually  require  ninety- 
seven  years  to  approximately  balance  the  in- 
vestment. 

A  ten  per  cent  replacement  reserve  ^^ charge 
on!'  included  in  the  expenses  of  operation  will 
provide  the  funds  for  replacement  in  ten 
years.  The  "charge  on"  is  the  correct  method. 

The  term  of  years  or  period  established  as 
the  probable  efficient  life  of  a  machine  is  prac- 
tically the  only  arbitrary  factor  in  Cost  Engi- 
neering. 

Reference  has  been  made  here  only  to  de- 
preciation of  the  machinery  values.  Prac- 
tically all  assets  depreciate,  and  provision 
must  be  made  for  maintaining  economic  equi- 

46 


Economic  Expenses 


librium  to  avoid  losses.  The  more  important 
items  are: 

Depreciation  of  buildings. 
Depreciation  of  equipment. 
Depreciation  of  raw  material  stocks. 

Depreciation  of  merchandise  and  finished 

product  stocks. 
Waste  from  cutting  materials. 

Spoilage  due  to  the  hazard  of  operations, 
and  inefficiency  of  workmen. 

Losses  from  bad  accounts  and  the  expenses 
of  collections. 

Depreciation  of  good  will.  In  cases  where 
good  will  has  been  purchased  outright, 
a  reserve  should  be  provided  which 
will  balance  the  investment  within  the 
period  where  the  influence  of  the  pur- 
chased good  will  is  likely  to  be  ex- 
hausted. 

Patents  should  be  carefully  appraised,  and 
provision  made  for  royalties  to  be 
charged  against  product,  which  will 
yield  their  value,  in  addition  to  normal 
profits,  within  the  period  of  protection. 

Interest   on   Investment   is    a    subject   on 
which  there  has  been  almost  endless  discussion 

47 


Fundamentals  of  Cost  and  Profit  Calculation 

for  want  of  proper  consideration  of  funda- 
mental principles. 

Interest  on  investment  is  a  form  of  wages 
for  energy  employed  by  the  business  and  must 
be  provided  for  before  profit  exists. 

The  expenses  of  fuel,  supplies,  and  main- 
tenance, pay  for  the  mechanical  energy  em- 
ployed by  the  business. 

The  wages  and  salaries  paid  to  individuals 
pay  for  the  personal  energy  of  workers  em- 
ployed by  the  business. 

Interest  on  investment  is  simply  the  wages 
of  the  money  employed  by  the  business. 

Just  as  there  can  be  no  profit  until  after 
the  expenses  of  operation,  and  of  personal 
service,  have  been  paid,  there  can  be  no  profit 
until  after  the  wages  of  the  invested  capital 
are  paid. 

There  are  many  valid  arguments  in  favor 
of  interest  on  investment  being  charged  as  an 
element  of  operating  cost,  rather  than  consid- 
ering it  as  a  part  of  profits.    For  example: 

Assume  that  a  man  has  $50,000  invested  in 
safe  securities  yielding  the  usual  legal  rate  of 
interest  (or  wage)  of  six  cents  per  dollar  per 
year. 

This  man  is  holding  a  good  salaried  posi- 
tion which  pays  $5,000  per  year  for  his  per- 

48 


Economic  Expenses 


sonal  energy,  and  has  in  addition  the  annual 
income  of  $3,000  earned  by  his  investment. 

He  decides  to  engage  in  business  that  his 
money  may  earn  for  him  a  larger  return  under 
his  personal  management. 

He  draws  his  money  from  the  security  of 
investment  and  reinvests  it  in  a  business  enter- 
prise solely  in  the  hope  of  increasing  his  in- 
come. 

He  fixes  his  salary  at  the  old  figure  of 
$5,000  for  his  personal  service,  and  does  his 
best.  At  the  end  of  the  year  he  finds  that  the 
net  earnings  of  the  business  amount  to  only 
$1,500  or  three  per  cent  of  his  investment. 
Has  he  made  a  profit  of  $1,500? 

He  has  not.  His  business  venture  has  cre- 
ated a  net  loss  of  half  of  the  normal  and  legal 
wages  of  his  financial  energy.  He  has  lost 
$1,500  as  surely  as  though  in  his  old  position 
he  had  been  unable  to  draw  more  than  $3,500 
of  his  $5,000  salary. 

Suppose  that  during  the  next  year  he  does 
$100,000  in  business  and  his  net  earnings  aside 
from  his  salary  amount  to  $4,000.  What  profit 
has  he  made? 

He  has  made  a  profit  of  one  per  cent.  The 
legal  wages  of  the  money  invested  is  six  per 

49 


Fundamentals  of  Cost  and  Profit  Calculation 

cent,  or  $3,000.  His  profit  this  year  from  his 
business  venture  amounts  to  $1,000  on  a  turn- 
over of  $100,000,  which  is  one  per  cent. 

Interest  and  profit  should  never  be  con- 
fused, because  interest  is  considered  in  rela- 
tion to  investment,  while  profit  is  properly 
considered  only  in  relation  to  sales  or  turn- 
over. 

Accountants  sometimes  contend  that  if  it 
is  desirable  to  consider  interest  on  investment 
separately  from  profits,  it  may  be  done  at  the 
end  of  the  year,  by  setting  aside  from  the 
profits  an  amount  equal  to  the  legal  interest, 
calling  the  remainder  "net  profit." 

In  view  of  the  fact  that  the  majority  of 
modern  factories  make  up  goods  to  the  speci- 
fications of  the  customer,  with  a  price  quoted 
in  advance  of  making,  it  is  necessary  to  make 
estimates. 

No  estimate  is  complete  that  does  not  take 
into  consideration  every  element  of  expense 
that  will  immediately  or  eventually  be  con- 
sidered in  the  cost.  Otherwise,  how  could  the 
manufacturer  regulate  the  matter  of  profit? 
He  must  include  in  his  quotations,  in  addition 
to  the  estimated  cost,  an  amount  which  will 
provide  for  the  anticipated  percentage  of 
profit. 

50 


Economic  Expenses 


Profit  is  related  to  turnover,  and  not  to 
investment;  while  interest  is  related  to  invest- 
ment and  not  turnover,  the  two  items  cannot 
be  included  in  a  single  percentage. 

Much  of  the  confusion  of  thought  in  these 
matters  is  due  to  the  fact  that  neither  public 
nor  commercial  schools  teach  practical  meth- 
ods of  calculating  cost  and  profit. 

Before  leaving  this  subject,  let  us  take  an- 
other example  in  which  we  will  use  the  same 
individual  and  the  same  capital  as  in  the 
preceding  illustrations. 

In  this  instance  the  investor  requires  the 
use  of  $100,000,  while  his  personal  capital  is 
but  $50,000.  He  borrows  $50,000  at  six  per 
cent,  which  he  invests  jointly  with  his  own. 

(Those  of  our  accountant  friends  who 
deny  the  man  who  uses  his  own  capital  the 
right  to  charge  interest  on  it  as  a  part  of  the 
cost  of  doing  business,  never  question  the  pay- 
ment of  interest  on  borrowed  money  as  a 
legitimate  expense.) 

At  the  end  of  the  year  the  business  shows 
a  good  margin  of  profit,  after  paying  the  in- 
terest on  the  borrowed  money. 

Is  there  any  difference  in  the  status  of  the 
borrowed  money  employed  in  the  business, 

51 


Fundamentals  of  Cost  and  Profit  Calculation 

and  the  money  which  is  owned  by  the  man- 
ager?   Absolutely  not. 

If  he  succeeds  in  earning  enough  to  pay 
back  the  borrowed  money  should  he  then  fur- 
nish the  product  or  goods  to  his  customers 
cheaper  because  it  is  his  money  that  is  in- 
vested, rather  than  borrowed  money?  Such  a 
theory  is  as  ridiculous  as  the  claim  occasion- 
ally advanced  that  a  concern  has  no  rental 
expense  because  it  owns  the  building  it  occu- 
pies. 

Fundamentally,  all  industrial  activities 
are  conducted  with  private  capital.  Every 
enterprise,  corporate,  public  or  private,  must 
secure  its  financial  energy  from  private  sav- 
ings, the  result  of  ability,  energy  and  thrift 
on  the  part  of  individuals. 

Stocks,  bonds  and  notes  are  simply  forms 
of  loans.  The  actual  ownership  of  the  capi- 
tal does  not  change.  The  bond  or  stock  cer- 
tificate is  simply  evidence  that  the  individual 
owns  a  certain  amount  of  money  that  is  used 
in  the  enterprise  which  has  arranged  for  the 
issuance  of  the  form  of  document  received  as 
evidence  of  the  loan. 

That  rate  of  wages  (interest)  is  lower  as 
the  form  of  security  advances.     Government 

52 


Economic  Expenses 


bonds,  the  safest  form  of  loans,  pay  the  low- 
est rate,  because  the  risk  is  smallest. 

Commercial  loans  command  a  higher  rate 
because  the  risk  involved  is  greater.  Com- 
mercial paper  is  practically  guaranteed  by 
the  common  stockholders  of  the  concern  issu- 
ing it,  to  the  extent  of  the  stock  investment. 

The  holders  of  common  stock  in  an  enter- 
prise take  the  greatest  risk,  because  all  other 
forms  of  loans  come  first.  Therefore,  since 
they  take  the  greater  risk  of  loss  in  unprofit- 
able years  they  are  entitled  to  the  larger  re- 
turn of  the  profitable  years. 

The  chief  difference  between  a  common 
stock  certificate  and  a  bond  or  note  is  that  the 
former  provides  no  specified  rate  of  wage  or 
term  of  contract. 

However,  cost,  the  point  between  loss  and 
profit,  must  in  justice  be  determined  by  a 
method  of  calculation  which  will  place  every 
dollar  employed  in  the  business  upon  an 
equal  footing.  Cost  must  include  interest  on 
the  invested  capital  at  the  normal  rate,  the 
rate  that  the  business  must  pay  for  loans  made 
by  those  who  do  not  assume  the  same  risk  that 
the  stockholder  takes. 

Bookkeepers  and  accountants  are  accus- 
tomed to  charging  as  expense  only  the  inter- 

53 


Fundamentals  of  Cost  and  Profit  Calculation 

est  paid  on  borrowed  money.  The  Cost  En- 
gineer holds  that  interest  should  be  charged 
on  every  dollar  employed  in  the  business,  re- 
gardless of  ownership. 

The  ordinary  classifications  on  which  in- 
terest should  be  charged  include  the  invest- 
ment in : 

Real  estate  used  for  the  business. 

Buildings  used  for  the  business. 

Equipment,  factory,  office,  store,  etc. 

Raw  stocks  carried  to  facilitate  economi- 
cal production. 

Investment  in  work  in  process. 

Merchandise  carried  to  facilitate  quick 
service  to  customers. 

Finished  product  or  merchandise  carried 
for  customers'  accounts. 

Accounts  receivable. 

Cash  in  bank  for  use  of  the  business. 

These  items  cannot  be  added  together  and 
a  blanket  charge  made  of  the  mass.  Each 
must  be  considered  in  relation  to  its  employ- 
ment in  service  to  the  customers,  so  that  the 
man  who  buys  the  product  of  hand  tools  will 
not  pay  the  interest  on  investment  in  expen- 
sive machine  equipment. 

54 


Economic  Expenses 


Good  Will  is  another  item  that  seems, 
heretofore,  to  have  escaped  the  consideration 
of  thinking  men.  The  term,  as  commonly 
used,  seems  to  refer  to  the  force  of  habit  in 
causing  people  with  purchasing  power  to  con- 
tinue to  patronize  a  concern  after  it  has 
changed  ownership. 

This  type  of  so-called  "good  will"  is  of 
doubtful  value.  Notwithstanding  the  fact 
that  the  man  who  has  a  store  or  other  business 
for  sale  dilates  largely  on  the  value  of  the  good 
will  that  is  included  in  the  offer,  it  is  rare  in- 
deed that  the  new  owner  profits  much  by  rea- 
son of  "force  of  habit." 

Genuine  good  will  is  rarely  transferable 
in  total.  The  man  who  gains  by  it  is  the  man 
who  joins  an  organization  which  has  already 
established  a  valuable  good  will.  Complete 
change  of  ownership,  publicly  announced, 
carries  with  it  little  good  will. 

The  term  is  sometimes  applied  to  a  legiti- 
mate form  of  intangible  investment,  and  in 
such  cases  has  real  value  if  the  business  is  to  be 
continued  under  the  new  management  with- 
out radical  changes  in  character  or  policy. 

Practically  no  business  can  be  established 
without  going  through  an  unprofitable  period. 
Often  it  requires  a  year  or  more  to  get  the 

55 


Fundamentals  of  Cost  and  Profit  Calculation 

business  up  to  a  point  where  its  tangible  assets 
equal  the  amount  of  investment. 

The  time  of  the  persons  who  promote  the 
organization,  arrange  for  the  preparation  of 
the  building,  and  manage  the  affairs  prior 
to  the  date  when  business  actually  begins,  re- 
quires a  form  of  investment  that  does  not  show 
in  the  inventories.  The  expense  of  advertis- 
ing, printed  supplies,  and  other  unsalable  ne- 
cessities adds  to  this  investment. 

These  items  should  all  be  a  matter  of  rec- 
ord, and  provision  made  for  refunding  to  the 
treasury  all  such  items  before  profit  is  con- 
sidered. If  the  business  changes  hands  before 
such  refunding  takes  place,  due  consideration 
should  be  given  to  such  of  these  amounts  as 
have  not  been  refunded. 

Genuine  good  will,  however,  is  another 
matter.  It  is  the  very  foundation  of  perma- 
nent business.  Not  one  man  in  ten  can  de- 
fine it. 

Good  will  is  the  margin  of  service  deliv- 
ered to  the  customers  beyond  what  they  are 
asked  to  pay  for. 

If  you  sell  an  article  to  a  customer  at  a 
price  which  leaves  him  with  the  impression 
that  he  paid  all  or  more  than  it  was  worth  you 

56 


Economic  Expenses 


create  no  good  will.  But  if  you  deliver  an 
article  to  a  customer  at  the  moment  that  he 
needs  it,  and  it  is  made  so  well  that  he  never 
has  reason  to  make  a  complaint  about  it,  and 
the  price  is  such  that  he  feels  that  he  got  a 
square  deal,  you  have  delivered  a  margin  of 
service  which  will  come  back  to  you  in  future 
business  and  recommendations  of  your  service 
to  others. 

Good  will  is  transitory  in  its  nature.  Bad 
management  can  destroy  it.  Neglect  of  the 
interests  of  the  customers  causes  it  to  dissolve 
like  vapor. 

Where  good  will  is  actually  purchased  a 
reasonable  estimate  of  the  "period  of  influ- 
ence" should  be  made  and  a  reserve  provided 
for  and  established,  that  within  the  estimated 
period  will  refund  to  the  treasury  the  amount 
paid  for  it. 

In  the  chapter  on  "Determining  Cost"  an 
outline  will  be  submitted  to  cover  as  far  as  is 
practicable  all  the  items  of  "Economic  or  Ul- 
timate" expenses  and  the  methods  by  which 
they  are  to  be  included  in  cost. 


57 


Round  numbers  are  the  cloak  of 
ignorance;  definite  figures  form  the 
basis  of  action. 

Two  and  two  make  four  —  au- 
thorities do  not  differ.  Mathe- 
matics do  not  compromise. 

A  few  cents  in  a  cost  figure^  in  a 
job  estimate^  in  a  profit  percentage, 
mark  the  line  between  solvency  and 
bankruptcy — success  and  failure. 

Build  your  system  and  your  facts 
to  give  you  not  the  approximate,  the 
probable,  the  perhaps — but  the  pre- 
cise, the  actual,  the  definite. 

Be  exact. — ^^System." 


58 


CHAPTER  FIVE 

DETERMINING  COST 

There  was  a  time  in  the  history  of  Ameri- 
can industries  when  exact  information  about 
cost  of  production  was  of  very  little  impor- 
tance. That  day  has  long  since  passed  and 
will  never  return. 

At  the  moment  when  this  is  written  the 
American  business  man  is  confronted  with 
conditions  and  requirements,  made  acute  by 
war,  demanding  immediate  and  accurate  facts 
about  the  vital  elements  of  his  business. 

Unfortunately,  the  opportunities,  the  am- 
pleness  of  time,  and  the  normal  conditions  of 
business,  which  were  his  in  the  past,  and 
which  afforded  the  most  practicable  basis  for 
gaining  information,  were  neglected.  He 
stands  today  as  unprepared  from  the  economic 
standpoint  as  was  our  country,  from  the  mili- 
tary standpoint,  the  day  the  Lusitania  was  tor- 
pedoed. 

He  has  no  choice  but  to  get  into  action. 
He  must  meet  the  needs  of  the  hour.  Every 
helpful  idea  serves  to  lessen  the  weakness  of 
his  position  and  hasten,  the  time  when  he  can 
adequately  fulfill  the  demands  made  upon 
him. 

S9 


Fundamentals  of  Cost  and  Profit  Calculation 

Business  in  times  past  has  been  conducted 
in  a  wasteful  manner  by  rule  of  thumb  meth- 
ods. American  business  men  have  presented 
the  most  remarkable  examples  of  rapid  for- 
tune building,  but  the  methods  have  been 
hazardous.  While  some  have  climbed  the 
ladders  of  riches  quickly,  thousands  have 
fallen  by  the  wayside,  until  statistics  show  in 
normal  times  a  greater  percentage  of  commer- 
cial and  industrial  failures  in  this  country 
than  in  any  other  country  in  the  world. 

The  American  business  man  is  a  lover  of 
the  game.  He  is  apparently  always  ready  to 
take  a  chance.  But  the  time  has  come  when 
he  can  no  longer  take  chances.  The  require- 
ments of  the  nation  are  such  that  he  must  have 
at  his  finger  tips,  for  immediate  reference, 
more  complete  and  accurate  records  than  he 
ever  dreamed  that  he  would  need. 

He  may,  in  the  past,  have  been  willing  to 
plunge,  and  for  a  time  conduct  his  business 
without  profit.  Today  he  needs  profit  that 
he  may  not  only  survive  but  assist  in  the  sup- 
port of  his  Government  in  its  fight  for  the  lib- 
erty without  which  his  life  and  the  lives  of 
those  he  loves  would  be  blighted. 

One  of  the  greatest  hindrances  with  which 
he  has  to  contend  in  his  effort  to  meet  the 

60 


Determining  Cost 


emergency  of  the  hour,  is  the  deplorable  fact 
that  the  terminology  of  business  is  cluttered 
with  meaningless  terms  and  phrases.  Def- 
inite information  is  difficult  of  conveyance  be- 
cause each  individual  places  his  own  interpre- 
tation upon  the  words  that  he  hears  or  reads. 
There  is  no  established  terminology. 

Another  hindrance  is  that  methods  of  pro- 
cedure are  as  chaotic  and  uncertain  as  the 
words  and  phrases  by  which  the  effort  of 
transmitting  information  is  rendered  inef- 
fective. 

The  business  man  is  not  the  only  one  who 
is  embarrassed  and  baffled  by  the  fact  that 
business  has  neither  terminology,  principles 
nor  practical  outlines  of  procedure,  to  deter- 
mine the  cost  or  profit  in  any  transaction  of 
business. 

The  Government  officials  upon  whom  has 
been  placed  the  task  of  collecting  and  analyz- 
ing the  essential  information  are  in  little,  if 
any,  better  position. 

The  crying  need  of  the  time  is  for  definite 
statements  of  the  principles  of  cost  and  profit, 
for  practical  methods  of  applying  those  prin- 
ciples to  business  so  that  the  problems  may  be 
solved  within  the  least  possible  time  and  in 
such  a  nianner  that  there  shall  remain  no  op- 

61 


Fundamentals  of  Cost  and  Profit  Calculation 

portunity    for   misunderstanding   or   contro- 
versy. 

Definiteness  is  the  keynote  of  Cost  Engi- 
neering. 

Every  expense  element  is  definite.  It  is 
definite  in  amount  or  it  could  not  be  recorded. 
It  is  definite  in  purpose  or  it  would  not  be  au- 
thorized. Its  purpose  is  always  the  procure- 
ment of  a  definite  service  or  commodity  more 
advantageous  than  the  amount  of  money  in- 
volved, otherwise  the  exchange  would  not  be 
made.  The  advantage  gained  by  the  expen- 
diture imparts  a  definite  degree  of  benefit 
wherever  the  purchased  item  is  utilized. 

Correct  distribution  of  an  expense  item 
demands  that  the  charge  shall  always  be  made 
against  the  product  benefited,  and  if  more 
than  one  item  or  process  be  benefited  the 
charges  must  be  in  the  ratio  of  benefit  or  ad- 
vantage conferred. 

In  manufacture,  product  always  consists 
of  definite  materials,  to  which  have  been  ?iip- 
plitd  definite  amounts  of  the  time  of  definite 
formative  processes. 

Materials  are  measurable. 

The  expenses  involved  in  the  purchase, 
transportation,  storage,  and  handling  of  ma- 
terials can  be  definitely  determined. 

62 


Determining  Cost 


With  definite  specifications  for  materials, 
definite  information  as  to  expenses  involved, 
there  should  be  no  question  about  the  possi- 
bility of  determining  the  cost  of  materials  re- 
quired for  any  given  lot  of  product. 

Processes  are  definite. 

A  capable  engineer  can  in  a  short  time 
make  a  complete  list  of  the  processes  which 
any  given  factory  is  equipped  to  perform. 

The  expenses  required  for  the  operation 
of  processes  are  definite. 

The  purposes  for  which  the  expenditures 
are  made  are  definite. 

None  of  the  operating  expenses  have  any 
relation  to,  or  are  involved  in,  the  ratio  of 
wages  paid  to  workmen. 

Practically  every  expense  involved  in  the 
operation  of  manufacturing  processes  has  a 
definite  relation  to  the  element  of  time. 

Rent  is  paid  on  a  time  basis,  or  if  the 
building  is  owned  the  items  of  depreciation 
and  insurance  on  the  building,  and  interest 
and  taxes  on  the  investment  in  building  and 
land,  are  calculated  on  a  time  basis. 

As  between  the  processing  divisions  of  a 
factory  the  expenses  of  providing  the  housing 
facilities  are  calculated  by  the  use  of  the  fac- 
tors of  area  and  time. 

63 


Fundamentals  of  Cost  and  Profit  Calculation 

The  expenses  incident  to  the  equipment 
investment,  e.  g.  depreciation,  insurance,  in- 
terest and  taxes,  are  all  related  to  time.  The 
amount  of  investment  and  the  element  of  time 
are  the  important  factors. 

The  expenses  of  the  power  plant,  or  for 
purchased  mechanical  energy,  are  related  to 
time.  Horsepower  required  for  operating 
the  machines  and  the  time  of  operation  pro- 
viding the  means  of  determining  the  propor- 
tions of  power  expense  chargeable  to  process- 
ing divisions. 

The  superintendent  supervises  the  active 
time  of  productive  processes,  while  the  fore- 
men supervise  the  time  of  the  individual  em- 
ployes whether  classed  as  productive  or  non- 
productive. 

Water,  soap,  towels,  and  toilet  facilities 
are  required  for  the  convenience  of  every  in- 
dividual, during  the  time  that  he  is  in  the  fac- 
tory or  office.  These  items  are  related  to  per- 
sonal time. 

Supplies  consumed  in  the  operation  of  the 
processes  are  required  practically  in  propor- 
tion to  the  active  operating  time. 

Records  of  the  activities  of  manufactur- 
ing processes  and  individuals  require  the  use 
of  supplies  relatively  in  the  proportions  of 

64 


Determining  Cost 


the  active  time  of  the  processes.  Activity,  not 
idleness,  creates  the  necessity  for  the  expenses 
of  such  supplies  and  the  services  of  time- 
recording  and  cost-computing  clerks. 

The  normal  unit  of  time  measurement  is 
the  hour. 

The  logical  unit  of  process  measurement 
is  the  process  hour. 

The  cost  of  process  hours  w^ill  vary  with 
the  expense  elements  involved  and  the  num- 
ber of  process  hours  over  which  the  process 
expenses  must  be  averaged  to  get  the  average 
cost  of  the  process  hour. 

The  cost  of  a  process  hour  is  a  complete 
cost.  Every  element  involved  in  the  process 
having  been  included,  there  is  nothing  to  add 
or  subtract. 

The  total  of  the  expenses  involved  in  a 
given  process  during  a  given  period  of  time, 
divided  by  the  chargeable  (revenue  produc- 
ing) hours  of  that  process  actually  charged 
against  the  production  orders  during  the  same 
period,  determines  the  rate  at  which  such 
hours  must  be  charged  to  determine  the  cost 
of  that  process  as  applied  to  the  order. 

It  follows  that  the  total  charges  against  all 
production  orders  during  a  given  period  must 
practically  balance  with  the  total  of  the  ex- 

65 


Fundamentals  of  Cost  and  Profit  Calculation 

penditures  of  the  same  period.  (These  totals 
are  almost  invariably  within  one-quarter  of 
one  per  cent  of  an  exact  balance.) 

Wages  may  or  may  not  be  included  in  the 
process  hour  cost  rate,  at  the  choice  of  the  en- 
gineer. 

Wages  comprise  simply  one  element  in 
cost. 

Wages  have  no  relation  to  the  total  of  the 
process  hour  cost. 

Wages  are  always  related  to  time.  They 
are  computed  on  the  basis  of  time  worked  or 
pieces  processed  or  assembled.  Piecework 
rates  are  set  on  a  time  basis. 

Where  no  special  reason  exists  for  a  sepa- 
rate consideration  of  wages  they  should  al- 
ways be  included  as  one  of  the  elements  of 
the  process  hour  cost.  Inclusion  within  the 
hour  rate  materially  reduces  the  clerical  ef- 
fort required  for  the  operation  of  the  cost 
system. 

As  a  result  of  many  years'  study  of  the 
problems  of  Cost  Engineering  the  author  has 
formulated  a  schedule  of  fundamental  prin- 
ciples of  the  science  of  Cost  Engineering 
which  he  presents  herewith. 

These  principles  and  the  rules  of  appli- 
cation covered  in  the  various  phases  of  the 

66 


Determining  Cost 


subject,  as  discussed  in  this  book,  together 
with  the  effort  at  establishing  a  definite  term- 
inology of  Cost  and  Profit  calculation,  are  of- 
fered in  all  seriousness  as  a  nucleus  upon 
which  may  be  builded  a  recognized  science  of 
Industrial  and  Commercial  Procedure. 

In  presenting  the  following  schedule  of 
fundamental  principles  of  Cost  Engineering 
(Denham  Methods)  each  formal  statement 
of  principle  is  accompanied  by  a  brief  ex- 
planatory statement  which  it  is  hoped  will 
make  the  principle  more  readily  understood. 

/.  The  cost  of  an  item  of  product  is  the 
sum  of  the  expenses  involved  in  its  produc- 
tion  and  distribution  up  to  the  moment  at 
which  cost  is  determined. 

(Cost  is  the  price  at  which  the  item  may 
be  sold  without  either  loss  or  gain  to  the 
seller.) 

2.  Every  cost  element  (expense  item)  is 
definite  in  amount  and  purpose,  or  object,  and 
anticipates  a  beneficial  equivalent  in  service 
or  commodity. 

(Expenses  having  a  single  beneficiary  are 
^^direct"  expenses;  those  having  two  or  more 
beneficiaries  are  "indirect,"  and  require  dis- 
tribution.) 

J.  Indirect  expenses  may  be  grouped  for 
67 


Fundamentals  of  Cost  and  Profit  Calculation 

simultaneous  distribution  only  when  their 
benefits  are  measurable  by  a  common  unit,  and 
their  beneficiaries  participate  in  identical 
ratios. 

(The  inclusion  of  two  or  more  unrelated 
indirect  expense  items  in  a  single  account  or 
group,  as  "overhead,"  "burden,"  or  "general 
expense,"  obscures  the  purposes  of  the  ex- 
penditures and  renders  correct  distribution 
impossible.) 

4.  In  the  distribution  of  indirect  ex- 
penses, singly  or  grouped,  the  proportions  of 
benefit  conferred  indicate  the  proportions  of 
the  expense,  or  expense  group  total,  charge- 
able to  beneficiaries. 

(Rules  may  be  established  for  the  distribu- 
tion of  certain  common  indirect  expenses,  as  e. 
g.  Rent,  on  the  basis  of  used  floor  area,  but 
exceptions  to  the  rules  may  be  found  in  every 
factory.  Whenever  a  rule  and  its  principle 
are  in  conflict  the  principle  must  govern.) 

5.  Operating  units,  or  machines,  may  be 
grouped  and  the  cost  per  hour  averaged  only 
when  their  principal  expense  factors  are  in 
approximately  uniform  ratios,  and  the  output 
of  such  character  that  the  work  may  be  inter- 
changed between  the  units,  or  machines,  of 
the  group. 

68 


Determining  Cost 


(Although  two  or  more  machines  have 
practically  uniform  proportions  of  the  chief 
expense  elements,  as  rent,  investment,  power, 
wages  and  supervision,  if  the  character  of  the 
output  differs  so  that  work  is  not  interchange- 
able, one  may  be  operated  continuously  and 
the  other  spasniodically.  Under  such  condi- 
tions injustice  would  result  from  averaging 
cost  of  productive  hours.) 

6.  Contingent  expenses,  such  as  repairs, 
shrinkage,  normal  waste  and  loss  on  by-prod- 
ucts, constitute  legitimate  charges  against  pro- 
duction, 

(The  causes  of  such  expenses  and  losses 
serve  to  indicate  the  objectives  of  the  indivi- 
dual charges.) 

The  foregoing  principles  have  been  in 
practical  use  for  the  past  ten  years  by  an  or- 
ganization of  Cost  Engineers,  and  have  been 
tested  in  hundreds  of  instances,  so  that  the 
reader  need  not  feel  that  he  is  offered  anything 
experimental. 

Cost  Engineering  is  a  practical  science. 
It  is  as  simple  and  direct  as  mathematics. 
However,  it  cannot  be  learned  in  a  moment 
as  a  formula  may  be.  It  requires  conscientious 
effort  to  study  it  until  one  can  become  profi- 
cient in  its  application. 

69 


Fundamentals  of  Cost  and  Profit  Calculation 

The  author  does  not  wish  to  convey  the 
impression  that  the  reader  of  this  book  can 
immediately  install  a  Cost  Engineering  sys- 
tem in  his  factory  or  store  upon  the  informa- 
tion contained  herein.  The  subject  is  too  deep 
for  that. 

Treatises  on  various  subjects  broaden  our 
horizon,  and  give  us  a  better  grasp  on  the  art 
of  living.  Study  of  the  principles  of  chemis- 
try gives  us  a  better  understanding  of  chemi- 
cal actions  and  reactions,  but  only  the  few 
who  specialize  in  the  subject  and  take  meas- 
ures to  get  actual  experience  become  chemists. 

Not  every  man  who  studies  Cost  Engineer- 
ing will  become  a  Cost  Engineer,  but  all  who 
will  try  to  assimilate  the  principles  and  rules 
of  practice  will  be  better  business  men  because 
of  the  information  that  the  effort  provides. 

Few  manufacturers  realize  the  number  or 
variety  of  the  expenses  of  their  business.  No 
list  that  could  be  published  would  be  either 
complete  or  cover  exactly  the  conditions  of 
any  factory. 

The  following  list  of  the  more  common 
items  of  expense  is  offered  simply  as  sugges- 
tive of  the  various  kinds  of  expenses  and  ex- 
pense groups  which  must  be  considered  in  any 
effort  to  determine  cost  of  production,  or  the 
cost  of  doing  business. 

70 


Determining  Cost 


Advertising 
Advertising  Postage 
Automobile  Expense 

Bad  Accounts 
Belt  Lacing 
Belting 
Bookkeeping 

Clerical  Help 
Costkeeping 

Deductions  for  Errors,  etc. 

Discounts  to  Customers 

Donations 

Drivers'  Wages 

Dues,  Business  Organizations 

Electric  Current  for  Lighting 
Electric  Current  for  Power 
Errand  Boys 
Express  Charges 

Foreladies'  Wages 
Foremen's  Wages 
Freight 
Fuel 

Gas  for  Lights 
Gas  for  Heating 

Helpers'  Wages 

Insurance  on  Buildings 
Inventory  Clerk 

71 


Fundamentals  of  Cost  and  Profit  Calculation 

Insurance  on  Equipment 
Insurance  on  Finished  Stock 
Insurance  on  Raw  Stock 
Insurance  on  Work  in  Process 
Insurance,  Boiler 
Insurance  Liability 
Interest  on  Accounts  Receivable 
Interest  on  Building  Investment 
Interest  on  Cash  in  Bank 
Interest  on  Equipment  Investment 
Interest  on  Finished  Stocks 
Interest  on  Raw  Stock 
Interest  on  Real  Estate  Investment 
Interest  on  Work  in  Process 

Lubricating  Oil 

Manager's  Salary 

Officers'  Traveling  Expenses 
Other  Officers'  Salaries 

Porters'  Wages 
Postage — Commercial 

Rent 

Repairs  to  Building 

Repairs  to  Equipment 

Replacement  Reserve  for  Building 

Replacement  Reserve  for  Equipment 

Salesmen's  Commissions 
Salesmen's  Salaries 

72 


Determining  Cost 


Salesmen's  Traveling  Expenses 

Shrinkage  of  Merchandise  Stocks 

Signs 

Soap 

Spoiled  Work 

Superintendent's  Salary 

Stenographers 

Stockkeepers'  Wages 

Storage 

Supplies  for  Commercial  OfBce 

Supplies  for  Factory  Operations 

Supplies  for  Factory  Office 

Supplies  for  Sales  Office 

Taxes,  Corporation 

Taxes,  Income 

Taxes,  Personal  Property 

Taxes,  Realty 

Taxes  on  Profits 

Telegrams 

Telephones,  City 

Telephones,  Interior 

Telephones,  Long  Distance  Messages 

Towels 

Waste,  Cotton 

Waste  Paper  Baling 

Watchman 

Watchman's  Clock  Supplies 

Water  Rent 

Workmen's  Wages 

73 


Fundamentals  of  Cost  and  Profit  Calculation 

Modern  Business  is  complicated,  and  to 
be  successfully  conducted  requires  system. 
System  is  the  carefully  planned  and  finished 
highway  upon  which  management  may  speed 
to  the  goal  of  profitable  endeavor. 

Smart  alecks  are  fond  of  making  a  jest  of 
system,  but  successful  men  know  that  they  are 
essential  to  economy  of  operation.  A  few  are 
unable  to  draw  a  distinction  between  system 
and  red  tape. 

System  requires  routine,  but  red  tape  is  the 
extreme  in  which  the  effort  of  systematizing 
has  shot  over  the  mark  and  adopted  or  created 
routine  that  is  either  without  purpose  or  is 
unprofitable.  The  author  of  the  routine, 
working  from  formula  rather  than  guided  by 
fundamental  principles,  is  unable  to  eliminate 
nonessentials,  and  establishes  useless  opera- 
tions, thereby  defeating  the  purpose  for  which 
he  is  striving.  Men  of  narrow  vision,  assum- 
ing that  the  application  of  these  formulas  rep- 
resents system,  condemn  all  efforts  of  estab- 
lishing systems  except  those  of  their  own  de- 
vising. 

Practical    systems    must    be  built  upon 
74 


Determining  Cost 


sound  fundamentals.     Neither  theories,  for- 
mulas, nor  personal  opinions  will  suffice. 

It  is  not  the  purpose  of  this  book  to  offer 
any  special  form  of  system,  but  rather  to  pre- 
sent the  fundamentals  of  Cost  and  Profit  cal- 
culation in  such  a  manner  that  the  reader  may 
work  out  his  own  problems  with  a  better  un- 
derstanding because  of  the  information  herein 
offered. 

In  establishing  any  cost  system  it  is  essen- 
tial that  an  effort  must  be  made  to  simplify 
the  work  as  far  as  possible,  keeping  in  mind 
the  factors  of  accuracy,  comprehensiveness 
and  practicability. 

It  is  a  rule  in  Cost  Engineering  practice 
to  place  accuracy  in  the  first  place  among  the 
requisites  of  a  system.  However,  there  is  a  de- 
gree of  accuracy  beyond  which  it  is  not  prac- 
tical to  go.  The  limit  is  watched  by  keeping 
in  mind  the  further  rule  that  ^When  the  cost 
of  the  effort  approximates  the  value  of  the  re- 
sult it  is  unprofitable  to  go  further."  In  other 
words,  all  effort. must  yield  a  profit  to  be  de- 
sirable. 

"Practical  accuracy"  is  defined  as  a  degree 
of  accuracy  to  go  beyond  which  affects  neither 

75 


Fundamentals  of  Cost  and  Profit  Calculation 

the  selling  price  of  the  product  nor  the  profits. 
Anything  not  affecting  the  profits  is  neutral 
and  may  be  done  or  omitted  according  to  the 
judgment  of  the  Engineer  as  to  the  im- 
portance of  the  result. 

Simplicity  is  facilitated  by  grouping  ex- 
penses for  distribution. 

The  simplest  possible  form  of  grouping  is 
that  which  conforms  to  the  third  principle  in 
the  schedule.  The  indirect  expenses  in  the 
following  list  have  been  grouped  as  nearly  as 
possible  according  to  that  principle.  How- 
ever, in  any  factory  the  conditions  may  re- 
quire changes  from  the  plan  presented  here- 
with. 
\j 

Building  Expenses: 

Rent,  or.  Replacement  reserve  and  insur- 
ance on  building,  and  interest  and  taxes 
on  investment  in  building  and  realty. 
Heat 

Janitor  Service 
Building  Repairs 

Equipment  Expenses: 

Replacement  Reserve 
76 


Determining  Cost 


Interest  on  Investment 
Insurance  on  Equipment 
Taxes  on  Equipment 

Power  Expenses: 

Total  of  Equipment  Expense  on  power 
equipment 

Total  of  Building  Expense  chargeable  to 
power 
Repairs 

Wages,  Supplies,  etc.,  for  power  depart- 
ment, including  fuel 

Current  (if  purchased  from  central  sta- 
tion) 

Light  and  Toilet  Expenses: 

Current  or  Gas  for  Lighting 
Lamps,  Cords,  Tips,  Globes,  etc. 
Water  for  Lavatories,  Soap,  Towels,  etc. 

Factory  Administration  Expenses: 

General  Superintendent 

Factory  Clerks 

Factory  Office  Expenses 

Factory  Phones,  Telegraph  and  Postage 

Factory  Stationery  and  Office  Supplies 

Porters  and  Elevator  Operators 

77 


Fundamentals  of  Cost  and  Profit  Calculation 

Commercial  Administration  Expenses: 

Executive  Salaries 

Office  Salaries,  except  factory  and  sales 

Telephones  and  Postage 

Stationery  and  Office  Supplies 

Bad  Accounts  and  Collection  Expenses 

Discounts  and  Deduction  to  Customers 

Federal  and  Corporation  Taxes 

Interest  on  Work  in  Process 

Interest  on  Accounts  Receivable 

Insurance  on  Work  in  Process 

Craft  Organization  Dues  and  Traveling 

Expenses 

Selling  Expenses: 

Sales  Manager 
Sales  Office  Salaries 
Salesmen's  Salaries  and  Commissions 
Sales  Traveling  Expense 
Sales  Phones  and  Telegraph 
Stationery  and  Supplies 
Advertising  and  Postage 
Samples  and  Sample-making 
Donations 

Local  Organization  Dues,  etc. 
Finished     Stockroom     Expense     (condi- 
tional) 

78 


Determining  Cost 


Packing  and  Local  Delivery: 

Rent,  Packing  and  Shipping  Dept 
Equipment  Expense,  P.  &  S.  Dept. 
Supplies,  P.  &  S.  Dept. 
Trucks,  Stables,  etc. 
Wages 

Stock  or  Merchandise  Departments:     (Raw 
and  Finished  should  be  considered  sepa- 
rately) 
Rent 

Equipment  Expense 
Insurance  on  Mdse.  Carried 
Interest  on  Investment  in  Stocks 
Taxes 
Shrinkage 
Light,  etc. 

Commercial  (purchasing,  etc.) 
Transportation 
Supplies 

Selling  Expenses 
Wages 

When  attempting  to  distribute  expenses 
the  reader  should  keep  in  mind  the  fact  that 
each  division  is  chargeable  only  with  such  ex- 
penses or  proportion  of  expenses  as  have 
actually  been  involved  in  the  production  of 
the  output  of  the  division  so  charged. 

79 


Fundamentals  of  Cost  and  Profit  Calculation 

The  common  bases  of  distribution  follow: 

Building  Expenses — Area  of  used 
space 

Equipment  Expenses  —  Replacement 
value  of  equipment 

Power  Expenses — Horsepower  hours 

Light  and  Toilet  Expenses — Personal 
hours,  or  payroll  hours 

Factory  Administration  Expenses  — 
Chargeable  hours 

Commercial  Administration  Expenses 
— Extended  values  at  cost 

Selling  Expenses — Extended  values  at 
cost,  when  sold 

Packing  and  Local  Delivery — ^To  be 
determined  by  circumstances 

Raw  Stock  Expenses — Frequently  ap- 
plied on  basis  of  cost  of  material  but 
requires  special  attention 

Finished  Stock  Expenses — Applied  by 
percentage  to  stock  carried  for  custom- 
ers, or  through  selling  expense,  accord- 
ing to  conditions 

Foremen's  Wages — Payroll  hours  of 
divisions  supervised  by  each 

80 


Determining  Cost 


Generally  speaking,  the  use  of  the  thing 
purchased  will  indicate  the  proportions 
chargeable  to  divisions.  This  is  not  always 
just. 

When  all  the  expenses  of  the  factory  and 
its  business  departments  have  been  properly 
analyzed,  grouped  and  distributed  in  propor- 
tion to  the  benefit  conferred  by  each,  the  cost 
per  hour  of  each  process  is  determined.  This 
is  done  by  dividing  the  total  of  the  divisional 
expense  by  the  number  of  chargeable  or  rev- 
enue producing  hours  that  have  been  charged 
to  the  factory  orders  during  the  period  cov- 
ered by  the  expenses  considered. 

All  product  of  factories  consists  of  com- 
binations of  materials  and  the  time  of  the  nec- 
essary formative  processes. 

Materials  are  to  be  charged  to  factory 
orders  at  cost,  which  includes  not  only  the 
purchase  price  as  shown  on  the  invoices,  but 
all  expenses  of  warehousing,  protecting  and 
handling,  not  omitting  interest  on  invest- 
ment. 

The  cost  of  materials  plus  the  cost  of  proc- 
esses as  determined  by  Cost  Engineering  con- 
stitutes the  cost  of  the  order.  All  expenses 
being  included  in  the  process  hour  rates,  noth- 
ing is  to  be  added  except  net  profit. 

81 


Fundamentals  of  Cost  and  Profit  Calculation 

In  factories  where  product  is  made  for 
stock,  and  sold  later,  the  selling  expense 
should  not  be  included  in  the  process  hour 
rates,  but  should  be  applied  to  the  order  when 
sold.  In  such  instances  the  expenses  of  ware- 
housing the  finished  product  should  be  ap- 
plied with  the  selling  expenses. 


CHAPTER  SIX 

SELLING  PRICES  AND  PROFITS 

The  object  of  all  commercial  and  indus- 
trial activity  is  profit.  In  fact  it  might  be  said 
that  the  object  of  all  human  effort  is  profit. 
The  first  statement  refers  to  the  reward  of  in- 
dustry, money;  while  the  second  refers  to 
various  types  of  reward,  such  as  the  comforts 
of  life,  the  good  will  and  friendship  of  neigh- 
bors, and  self-respect  as  well  as  financial  re- 
ward. This  chapter  deals  with  the  reward  of 
industry  and  commerce — profit,  as  expressed 
in  terms  of  money. 

The  legitimate  reward  of  business  is 
profit.  In  fact,  commercial  activity  that  is  un- 
profitable is  not  business ;  it  is  folly.  The  man 
who  is  responsible  for  unprofitable  conditions 
of  business  is  a  menace  to  the  community  and 
to  the  state.  He  places  in  jeopardy  the  capital 
and  income  of  the  stockholder  who  has  en- 
trusted to  him  the  profitable  use  of  his  money; 
he  destroys  the  basis  of  credit  and  adds  to  the 
risk  of  the  creditor  whose  confidence  he 
abuses ;  he  injures  the  business  of  his  competi- 
tor who  is  striving  to  conduct  his  business  on 
sound  principles;  he  weakens  the  support  of 

83 


Fundamentals  of  Cost  and  Profit  Calculation 

the  family  that  loves  and  depends  upon  him ; 
he  injures  his  Government  by  curtailing  its 
sources  of  revenue  and  nullifying  its  efforts 
for  welfare  and  prosperity  of  its  people;  but 
most  of  all,  he  injures  himself. 

The  fabric  of  humanity  is  so  closely  and 
delicately  interwoven  that  the  failure  of  one 
individual  to  recognize  his  responsibilities  af- 
fects adversely  the  welfare  of  hundreds  and 
often  thousands  of  his  fellows. 

Business  must  yield  profits  or  failures  will 
result. 

All  business  is  buying  and  selling. 

The  merchant  buys  goods  and  resells  them 
in  the  same  form,  but  because  he  adds  an  ele- 
ment of  service  he  is  entitled  to  a  profit. 

The  manufacturer  buys  materials  in  one 
form,  changes  them  to  another  which  his  cus- 
tomers desire,  adding  also  the  element  of  serv- 
ice, and  is  entitled  to  profit. 

Neither  would  put  forth  the  effort  to  serve 
his  fellows  were  it  not  for  his  anticipation  of 
the  reward,  or  profit. 

Profit  is  the  amount  by  which  the  selling 
price  of  a  sold  item  exceeds  its  cost. 

This  definition  of  profit  covers  several  im- 
portant points :    (a)  the  determination  of  cost, 

84 


Selling  Prices  and  Profits 


SO  that  there  may  be  certainty  that  the  selling 
price  is  higher;  (b)  determination  of  a  selling 
price  that  will  at  once  yield  a  profit  and  not  be 
so  high  that  prospective  customers  will  refuse 
to  buy;  (c)  the  fact  that  the  item  must  be  sold 
before  there  can  be  a  profit. 

It  is  an  unfortunate  fact  that  nine-tenths 
of  the  men  engaged  in  business  do  not  know 
how  to  determine  correctly  either  the  cost  or 
the  selling  price  of  the  goods  they  sell.  The 
reader  may  doubt  this  but  his  skepticism  will 
not  change  the  facts.  He  may  be  one  of  those 
who  are  using  wrong  methods  without  know- 
ing it. 

The  author  has  stated  elsewhere  that 
neither  the  public  schools  nor  the  commercial 
schools,  generally,  teach  these  subjects  cor- 
rectly. Fortunately,  there  are  a  few  excep- 
tions. If  this  book  shall  have  the  effect  of 
waking  up  a  few  more  it  will  have  accom- 
plished enough  to  warrant  its  authorship  and 
publication. 

The  best  dictionaries  offer  definitions  of 
cost  and  profit  which  are  in  accord  with  tra- 
ditional methods  but  not  practical  for  modern 
business. 

In  thus  antagonizing  the  so-called  authori- 
ties of  schools  and  reference  books  the  author 

85 


Fundamentals  of  Cost  and  Profit  Calculation 

does  not  wish  to  be  understood  as  setting  him- 
self up  as  a  higher  authority.  He  presents  his 
claims  to  the  confidence  of  his  readers  solely 
upon  the  basis  of  their  practicability  for  use 
with  modern  business  methods. 

These  are  not  matters  in  which  a  common 
agreement  can  govern. 

The  school  teachers,  college  professors  and 
compilers  of  dictionaries  may  be  eminently 
capable  from  the  standpoint  of  classical  edu- 
cation, but  the  author  and  the  business  men  of 
the  day  are  dealing  in  the  facts  of  trade  as  they 
are,  and  as  they  are  unknown  to  the  eminent 
authorities  who  prepare  textbooks  and  dic- 
tionaries. 

When  the  compiler  of  the  dictionary  pre- 
sents the  definition  of  cost  as  "the  price  paid 
for  an  item"  it  is  evident  that  he  has  in  mind 
as  the  price  the  consumer  pays  for  the  article, 
the  price  he  paid  for  his  last  suit  of  clothes  or 
for  a  book. 

When  the  educator  refers  to  the  diction- 
ary and  finds  the  definition  just  quoted,  his 
mind  instantly  accepts  the  statement  as  true 
because  his  own  experience  is  identical  with 
that  of  the  lexicographer  who  wrote  the  defi- 
nition. 

86 


Selling  Prices  and  Profits 


However,  when  the  merchant  or  the 
manufacturer  has  occasion  to  use  the  term 
"cost"  it  means  something  entirely  different. 
It  means,  not  the  purchase  price  alone,  but  the 
purchase  price  plus  all  of  the  expenses  in- 
volved in  manufacture  and  distribution  up  to 
the  moment  at  which  the  cost  is  determined. 

Much  has  been  said  in  previous  chapters 
about  determining  the  cost  of  production  in  a 
practical  manner,  and  the  weakness  of  the  old 
methods  or  traditions  of  cost  accounting. 
This  chapter  is  intended  to  cover  those  ele- 
ments of  business  having  to  do  with  the  dis- 
tribution of  the  product  after  it  is  made  and 
the  cost  of  manufacture  determined — ^with 
"Selling  Prices  and  Profits." 

Merchandising,  like  manufacturing,  is  a 
simple  proposition  if  but  one  class  of  mer- 
chandise is  handled,  but  in  the  department 
store  where  each  class  of  goods  is  separated 
from  other  classes  by  the  limitations  of  de- 
partments there  is  large  opportunity  for  the 
profitable  application  of  Cost  Engineering. 

Sales  are  the  source  of  revenue  of  business. 
In  merchandising,  as  in  manufacturing.  Cost 
of  Selling  must  necessarily  be  a  charge  against 
sales.    No  expense  can  be  charged  against  in- 

87 


Fundamentals  of  Cost  and  Profit  Calculation 

active  stocks  of  goods.  Every  expense  must 
be  provided  for  from  revenue.  Goods  that  do 
not  move  are  a  liability. 

In  the  simple  store,  selling  a  single  class 
of  goods,  the  cost  of  selling  absorbs  a  part  of 
the  margin,  the  remainder  of  which  consti- 
tutes profit. 

Margin  is  the  difference  between  the  pur- 
chase price  and  the  selling  price  and  consists 
of  the  cost  of  selling  and  the  profit.  Margin 
is  sometimes  erroneously  miscalled  ^^gross 
profit,"  but  since  the  nature  of  profit  is  such 
that  it  is  always  net,  the  latter  term  is  mis- 
leading. 

Under  the  textbook  theory  a  margin,  or 
"gross  profit,"  can  be  added  to  the  purchase 
price  of  the  item  to  determine  the  price  at 
which  it  must  be  sold  to  yield  a  profit  of  the 
desired  percentage. 

The  same  textbooks  that  teach  that  profit 
is  a  percentage  in  addition  to  cost  (the  as- 
sumption being  that  purchase  price  repre- 
sents the  base  or  cost) ,  teach  that  commission 
paid  for  making  the  sale  (a  part  of  the  selling 
expense)  is  to  be  considered  as  a  percentage  of 
the  selling  price. 

88 


Selling  Prices  and  Profits 


These  teachings  are  inconsistent  and  im- 
practical, not  only  from  the  standpoint  of 
modern  methods,  but  there  never  was  a  time 
when  they  were  practical.  The  effect  of  mod- 
ern conditions  has  not  increased  their  imprac- 
ticability, but  it  has  greatly  increased  the  dan- 
ger to  the  welfare  of  business  men  of  continu- 
ing their  use. 

The  accountants  long  ago  should  have  in- 
sisted upon  their  correction.  The  only  reason 
apparent  for  their  not  doing  so  is  the  fact  that 
the  nature  of  accounting,  being  purely  rou- 
tine, does  not  develop  the  reasoning  faculties 
and  deadens  the  creative  faculties.  The  ac- 
countant must  have  no  imagination.  His  busi- 
ness is  to  record  history. 

Standard  practices  of  accounting  have  the 
same  relation  to  the  transactions  of  business 
that  the  crafts  of  undertaking  and  monument 
erecting  have  to  the  human  race — they  bury 
them  and  preserve  their  memory  by  records. 

Accounting  might  be  quickened  into  a 
thing  which  would  serve  to  create  profits  if 
the  devotees  were  not  so  bound  to  traditional 
^^standard  practices"  and  used  their  mentali- 
ties instead  of  leaning  upon  the  so-called  au- 
thorities. 

89 


Fundamentals  of  Cost  and  Profit  Calculation 

Modern  business  is  done  on  narrow  mar- 
gins. The  facts  of  Cost  and  Profit  must  be 
known.  Traditional  theories  at  variance  with 
the  facts  are  dangerous  and  will  not  serve. 

The  modern  store,  of  the  better  class,  is  a 
complicated  affair.  It  involves  the  sale  of 
many  kinds  of  merchandise,  each  having  a 
different  rate  or  percentage  of  turnover. 
Each  requires  a  different  amount  of  space, 
special  equipment,  and,  in  many  lines,  spe- 
cially trained  and  experienced  salesmen. 

Payment  for  the  service  of  salesmen  may 
be  made  either  by  salary  or  commission,  some- 
times both.  In  some  instances  the  employer 
pays  the  expenses  of  the  salesman.  In  other 
instances  the  salesman  must  pay  his  expenses 
out  of  his  earnings.  The  departmental  clerk 
within  the  store  may  have  no  item  correspond- 
ing to  the  traveling  expense  of  the  outside 
salesman,  but  he  may  receive,  as  part  of  his 
compensation,  a  bonus  calculated  upon  any 
one  of  numerous  bases  recently  devised  and 
inaugurated. 

In  addition  to  the  compensation  of  indi- 
viduals the  expenses  of  rental,  fixtures,  sup- 
plies and  administration  correspond  very 
nearly  to  those  of  the  manufacturer. 

90 


Selling  Prices  and  Profits 


With  margins  narrowed  by  either  the 
keenness  of  intelligent  competition,  or  the 
blunders  of  ignorant  competitors,  the  im- 
portance of  extra  cost  knowledge  enlarges  to 
serious  proportions. 

The  future  of  trade  and  commerce  de- 
mands that  efforts  be  made  at  the  earliest  mo- 
ment to  get  into  practice  a  code  of  procedure 
and  a  terminology  easily  comprehended  and 
practical  in  use. 

As  little  change  from  present  usages  as  is 
necessary  in  such  a  movement  to  attain  the  re- 
sult is  desirable.  This  may  be  accomplished 
if  interest  can  be  aroused  to  the  extent  neces- 
sary to  accelerate  action.  It  may  take  a 
decade  to  attain  the  result  but  the  longer  the 
start  is  postponed  the  farther  into  the  future 
is  pushed  the  time  of  attainment.  How  shall 
it  be  done? 

Contrary  to  traditional  formula  and  prac- 
tice. Cost  Engineering  proves  that  the  opera- 
tion of  the  department  store  and  the  composite 
factory  are  identical  in  principle. 

The  costs  of  each  department  or  division 
are  determined  by  very  similar  processes. 
When  the  cost  is  known  it  remains  to  de- 
termine the  selling  prices  and  the  amount  of 
profit  desired  or  obtained. 

91 


Fundamentals  of  Cost  and  Profit  Calculation 

First — All  percentages  used  in  connection 
with  the  handling  and  sale  of  product  and 
merchandise  should  relate  to  the  same  base. 
The  only  logical  base  developed  by  analysis 
of  the  facts  is  the  selling  price  in  the  individ- 
ual sale,  and  the  total  of  sales,  in  the  period- 
ical calculation. 

Selling  price,  the  base,  is  always  repre- 
sented by  loo  per  cent. 

The  following  items  must  be  recognized 
as  related  to  selling  price,  or  sales,  as  the  base: 

Expenses  of  selling  of  every  nature  must 
be  calculated  as  percentages  of  the  base — 
selling  price,  not  purchase  price. 

Profit  must  always  be  calculated  as  a  per- 
centage of  the  base — selling  price,  not  pur- 
chase price. 

The  more  intelligent  and  advanced  busi- 
ness men  are  doing  this  at  present,  but  their 
number  is  less  than  ten  per  cent  of  the  whole. 

Many  concerns  have  adopted  a  fixed  per- 
centage which  they  add  to  the  purchase  price 
of  goods  to  be  sold,  as  a  means  of  determining 
the  price  at  which  they  are  to  be  sold,  re- 
gardless of  classification  of  the  items  or  the 
amount  of  the  turnover  developed.  They  take 
a  chance  on  profits  and  do  not  know  what  rate 

92 


Selling  Prices  and  Profits 


of  profit  is  made  on  the  whole  of  the  turnover 
until  the  end  of  the  period  or  year.  They 
never  know  the  rate  of  profit  actually  made 
on  the  individual  item  or  classification. 

Notwithstanding  that  calculations  for  the 
purpose  of  making  selling  prices  of  individual 
items  are  usually  made  with  the  purchase 
price  as  the  base,  the  profits  of  a  definite 
period  are  almost  universally  based  upon  the 
volume  of  sales.  For  example:  A  concern 
having  sales  amounting  to  $100,000  for  the 
year,  finding  that  they  had  developed  net 
profits  amounting  to  $10,000,  would  unhesi- 
tatingly aver  that  they  had  made  a  profit  of 
ten  per  cent. 

As  an  example  of  the  confusion  of  bases 
on  the  part  of  business  men  the  author  will 
cite  an  actual  incident  that  came  under  his 
personal  observation: 

While  discussing  this  subject  with  a  de- 
partment manager  in  a  store  consisting  of  sev- 
eral departments  the  statement  was  made  that 
it  cost  twenty-eight  cents  of  expense  on  every 
dollar  of  goods  sold  during  the  previous  year. 

The  manager  was  asked  how  he  deter- 
mined the  selling  price  on  an  article.  He  re- 
plied that  he  took  the  purchase  price  and 
added  twenty-eight  per  cent  to  it  to  get  the 

93 


Fundamentals  of  Cost  and  Profit  Calculation 

cost,  and  then  added  an  additional  percentage 
to  the  total  for  profit. 

He  was  then  requested  to  determine  at 
what  price  he  would  sell  an  article,  the  invoice 
price  of  which  was  $6.20,  if  the  desired  profit 
was  ten  per  cent.  His  calculation  showed  the 
following : 

Purchase  price  of  item $  6.20 

Expense  of  doing  business  28% 

of  $6.20 1.74 

Total     cost,     including    ex- 
penses       7.94 

Add  10%  of  total  for  profit 80 

Selling  price  $  8.74 

The  author  knew,  and  called  attention  to 
the  fact,  that  the  store  was  being  operated  un- 
der a  receivership,  prima  facie  evidence  that 
there  was  something  wrong  with  its  busi- 
ness methods. 

He  then  briefly  demonstrated  to  the  man- 
ager the  correct  method  of  determining  the 
cost  and  selling  price  that  will  yield  a  certain 
profit  on  the  sale,  as  follows: 

94 


Selling  Prices  and  Profits 

Selling  price  represented  by ioo% 

Expense  of  doing  business  28% 
Profit  percentage  desired   10%, 
Total  of  percentage  other  than 
purchase  price  38% 

Percentage   representing  pur- 
chase price  62% 

The  invoice  price  of  the  item  was  $6.20. 
This  amount  divided  by  62  gives  one  per  cent 
of  the  selling  price,  or  $10,  which  multiplied 
by  100  produces  100  per  cent,  or  the  selling 
price,  in  this  instance  $10.00.  In  practice  the 
selling  price  is  found  by  moving  the  decimal 
point  two  spaces  to  the  right,  thus  changing 
$.10  to  $10. 

28  per  cent  of  $10.00  allows  $2.80  for  ex- 
penses. 

The  profit  being  10  per  cent  is  $1.00. 
The  cost  of  sale  is  $9.00. 

According  to  the  old  plan  the  price  was 
incorrectly  determined  and  the  article  sold  for 
less  than  cost.  This  in  itself  accounts  for  the 
receivership. 

Round  figures  were  used  for  purposes  of 
illustration.  Had  the  invoice  or  purchase 
price  been  $7.53,  that  amount  divided  by  62 

95 


Fundamentals  of  Cost  and  Profit  Calculation 

would  have  yielded  $.1215,  or  a  selling  price 
of  $12.15.  The  result  in  any  case  may  be 
proven  by  calculating  the  given  percentages 
of  the  total. 

With  the  principles  of  Cost  Engineering 
applied  to  determine  the  amount  of  expenses 
chargeable  to  each  class  of  sales,  it  w^ill  be 
found  that  when  the  expenses  of  the  depart- 
ment are  considered  in  relation  to  the  amount 
of  turnover  of  that  class  of  sales,  a  different 
percentage  of  cost  will  be  found  for  each. 

The  rate  of  profit  should  differ  on  differ- 
ent classes  of  goods.  It  is  ridiculous  to  assume 
that  one  rate  of  expense  and  profit  will  be 
practical  for  a  great  variety  of  lines  of  goods. 

In  any  case,  the  percentage  of  expense  and 
the  percentage  of  profit  added  together  and 
deducted  from  100  will  show  the  precentage 
of  the  selling  price  represented  by  the  pur- 
chase price.  The  purchase  price  divided 
by  the  number  per  cent  which  represents  it 
will  yield  one  per  cent  of  the  selling  price. 
This  multiplied  by  icmd  determines  the  selling 
price. 

When  the  departmental  or  "line"  percent- 
age has  been  established  for  a  period,  all  that 
is  necessary  in  determining  the  selling  price  of 

96 


Selling  Prices  and  Profits 


any  item  is  to  divide  its  purchase  price  by  the 
percentage  and  set  the  decimal  two  points  to 
the  right. 

There  have  been  published  from  time  to 
time  schedules  of  percentages  which  could  be 
added  to  cost  to  produce  certain  percentages 
of  profit  on  the  sales.    For  example: 

To  make  a  profit  of  25  per  cent  add  33-1/3 
per  cent  to  cost. 

To  make  a  profit  of  20  per  cent  add  25  per 
cent  to  cost. 

To  make  a  profit  of  16-2/3  P^^  ^^^t  add 
20  per  cent  to  cost. 

Although  the  basic  principle  of  this  type 
of  schedule  is  correct  because  the  percentage 
of  profit  is  related  to  the  selling  price,  it  makes 
no  provision  for  the  expense  of  doing  busi- 
ness, is  necessarily  limited  to  the  percentages 
included,  and  uses  the  cost,  frequently  an  un- 
known quantity,  as  a  basis. 

The  following  incident  will  serve  to  show 
the  result  of  using  diflferent  bases  for  percent- 
ages and  the  confusion  likely  to  occur  where 
correct  methods  are  not  understood. 

One  of  the  principals  in  this  business  spent 
several  years  serving  as  bookkeeper  for  an- 
other concern  which  had  "failed  for  lack  of 
capital." 

97 


Fundamentals  of  Cost  and  Profit  Calculation 

The  author  was  told  that  the  business  was 
one  of  the  most  profitable  in  the  industry 
which  it  represented.  In  fact  they  boasted  a 
25  per  cent  profit,  which  was  extremely  un- 
usual for  that  class  of  manufacture.  To  prove 
that  this  was  true  they  stated  that  they  had 
paid  a  25  per  cent  dividend  a  month  previous 
to  the  date  of  the  interview. 

In  discussion  the  author  was  given  the  fol- 
lowing data  in  connection  with  the  business : 

Capital  Stock $100,000 

Sales  360,000 

Material  used 99j590 

Profits 27,280 

Their  plan  of  making  prices  was  as  fol- 
lows: 

Compute  the  cost  of  material  used  and  add 
33-1/3  per  cent. 

Compute  the  cost  of  manufacturing  pro- 
cesses and  add  33-1/3  per  cent. 

The  total  of  these  two  items  was  the 
selling  price,  and  should  yield  a  profit  of 
25  per  cent  on  the  sale. 

The  fact  that  they  were  able  to  pay  a  25 
per  cent  dividend  satisfied  them  that  they  had 
succeeded  in  making  25  per  cent  profit  for  the 
year.    It  had  not  been  noticed  that  while  they 

98 


Selling  Prices  and  Profits 


calculated  25  per  cent  on  sales  they  had  suc- 
ceeded in  making  only  25  per  cent  on  the  cap- 
italization. They  confused  the  percentage  of 
dividends  on  capital  with  the  profits  on  sales. 

When  asked  if  they  had  included  depre- 
ciation in  their  calculations  they  stated  that 
they  had  charged  off  their  customary  5  per 
cent.  Interest  on  investment  had  not  en- 
tered into  their  calculations  of  cost  or  income. 
They  admitted  the  justice  of  an  8  per  cent  re- 
serve for  replacement,  to  offset  the  deprecia- 
tion on  plant.  Taking  an  additional  3  per  cent 
for  depreciation,  and  allowing  6  per  cent  of 
total  investment  as  interest  expense,  their  prof- 
its dwindled  to  $18,940,  or  slightly  over  5  per 
cent  of  the  sales. 

It  was  easily  shown  that  the  addition  of 
one-third  to  the  cost  of  the  $99,590  of  mate- 
rials used  should  have  yielded  $33,177  net 
profit  on  materials  alone.  The  actual  net 
profit  being  $18,940,  it  was  evident  that  the 
factory  had  been  operated  at  a  loss  absorbing 
$14,237  of  the  profit  which  should  have  ac- 
crued on  the  materials. 

In  closing  this  chapter  it  is  advisable  to 
present  a  resume  of  the  more  salient  points 
of  the  relationship  of  the  various  financial 
items  encountered  in  connection  with  the  cal- 
culation of  Costs,  Selling  Prices  and  Profits. 

99 


Fundamentals  of  Cost  and  Profit  Calculation 

(a)  Manufacturing  Expenses:  On  ac- 
count of  the  extreme  variation  in  the  amounts 
of  various  items  required  by  the  different  pro- 
cesses, no  distribution  by  percentage  is  possi- 
ble. Each  item  must  be  charged  proportion- 
ately to  its  use,  or  its  benefit  to  the  individual 
process,  as  expressed  in  units  by  which  the 
item  itself,  or  its  use,  is  measured. 

(b)  Merchandising  Expenses:  Advertis- 
ing, selling  commissions,  rent  of  storerooms, 
and  all  other  expenses  in  connection  with  the 
sale  of  the  manufactured  goods,  or  materials, 
or  articles  bought  for  resale,  may  be  charged 
by  percentage  of  selling  price,  it  being  under- 
stood that  where  the  proportions  of  such  ex- 
penses differ  to  any  considerable  degree  on 
different  classes  of  merchandise,  each  class 
shall  be  charged  with  such  rate  as  will  cause 
the  sales  of  that  class  to  carry  their  just  pro- 
portion of  the  expenses  involved. 

(c)  Interest  and  earnings  always  to  be 
considered  at  a  rate  per  cent  per  annum  of 
the  amount  invested. 

(d)  Dividends  are  to  be  considered  at  a 
rate  per  cent  of  capital  stock  entitled  to  parti- 
cipate. 

(e)  Profits  are  always  to  be  considered  at 
a  rate  per  cent  of  the  amount  of  sales. 

100 


CHAPTER  SEVEN 

MAKING  COST  AND  PROFIT 
STATEMENTS 

The  Cost  and  Profit  Statement  is  the  pulse 
of  the  business,  the  index  of  its  vitality. 

The  executives  of  the  healthy  business  have 
no  difficulty  in  the  preparation,  and  no  em- 
barrassment to  anticipate  in  the  presentation, 
of  such  statements. 

The  business  that  is  weak  at  the  heart  is 
the  one  in  which  the  making  of  Cost  and  Profit 
Statements  gives  cause  for  uneasiness  and  fear. 

Statements  are  required  for  three  pur- 
poses: (a)  that  the  management  may  be  kept 
in  touch  with  the  vital  factors  of  the  business; 
(b)  as  a  basis  of  credit;  and  (c)  for  purposes 
of  taxation. 

Unfortunately,  there  are  people  who  fail 
to  realize  that  nothing  is  ultimately  profitable 
except  the  truth.  They  are  sorely  puzzled  in 
their  efforts  to  make  one  statement  serve  all 
purposes  with  results  to  their  liking. 

If  the  profits  do  not  show  up  well,  the 
statement  reflects  upon  the  ability  of  the  man- 
agement.    If  they  show  up  in  the  statement 

101 


Funjajnmtah  of  Cost  and  Profit  Calculation 

better  than  the  facts  warrant,  it  means  that  the 
concern  will  be  likely  to  both  deplete  its  work- 
ing capital  by  declaring  excessive  dividends 
and  pay  taxes  to  the  Government  of  fictitious 
earnings.  If  camouflage  is  used  with  the 
banker  he  may,  and  likely  will,  see  through 
it  to  the  detriment  of  credits. 

The  honest  manager  will  not  try  to  fool 
either  himself  or  his  directors,  because  if  the 
profits  are  not  what  they  should  be  their  best 
interests  are  served  by  knowing  it  so  that  the 
conditions  may  be  corrected. 

The  Government  wishes  to  be  fair,  and 
will  demand  only  its  share,  but  will  punish 
efforts  to  evade  just  taxation  wherever  it  finds 
them. 

The  banker  is  inclined  to  be  more  generous 
with  the  man  who  presents  an  honest  state- 
ment showing  small  assets  than  with  him 
whose  statement,  although  showing  large  as- 
sets, bears  the  earmarks  of  "doctoring." 

In  the  long  run  statements  at  different 
times  can  be  and  frequently  are  compared. 
Dishonesty  cannot  long  be  consistent. 

It  is  a  misfortune  that  there  are  managers, 
boards  of  directors,  and  even  accountants  who 
will  stoop  to  dishonesty  in  making  statements. 

102 


Making  Cost  and  Profit  Statements 

Corporations  have  been  known  to  pay  div- 
idends regularly  up  to  the  period  wherein  a 
receiver  took  charge  of  their  affairs  to  secure 
the  interests  of  the  creditors. 

Such  conditions  indicate  that  there  is 
something  fundamentally  wrong  with  meth- 
ods of  preparing  statements.  It  should  not  be 
possible  for  men  to  present  information  in 
forms  seemingly  truthful,  while  as  a  matter  of 
fact  they  are  widely  at  variance  with  the  truth. 

The  author  would  be  unfair  if  he  created 
the  impression  that  all  erroneous  statements 
were  dishonest. 

Many  of  them  are  made  by  men  who  sin- 
cerely wish  to  present  the  truth  about  their 
business,  but  they  do  not  know  how.  They 
either  have  been  taught  or  have  simply  ab- 
sorbed traditional  methods. 

Many  statements  made  up  by  public  ac- 
countants are  seriously  erroneous,  because  the 
accountant  either  does  not  know  the  facts,  does 
not  know  how  to  get  the  facts,  or  does  not 
know  how  to  present  the  facts. 

Another  thing  responsible  for  erroneous 
statements  where  honest  effort  has  been  made 
to  present  correct  information  is  the  uncertain 
terminology  of  business. 

103 


Fundamentals  of  Cost  and  Profit  Calculation 

How  shall  a  man,  be  he  accountant,  busi- 
ness man,  or  law  maker,  present  information 
correctly  when  he  must  do  so  in  words  that 
are  commonly  used  without  knowledge  of 
their  true  meaning? 

Take  the  word  "capital"  for  example.  The 
average  business  man  uses  it  in  at  least  two 
senses.  Unless  he  qualifies  it  the  hearer  can- 
not tell  whether  he  uses  it  in  the  sense  of  cap- 
ital stock,  a  liability,  or  capital  investment,  an 
asset. 

How  many  of  the  readers  of  this  book  can 
correctly  define  "earnings,"  "income"  and 
"profits?"  These  words  are  commonly  used 
interchangeably,  yet  each  has  a  distinct  mean- 
ing and  should  never  be  used  in  the  same  sense. 

The  author  has  yet  to  find  a  man  who  can 
tell  positively  whether  the  new  war  tax  on 
"profits"  is  actually  levied  against  "earnings," 
"income"  or  "profits."  It  is  evident  that  the 
men  who  framed  the  law  did  not  understand 
the  terminology  of  business. 

At  the  present  moment  there  is  reason  to  be 
generous  in  our  criticisms.  When  the  ac- 
counting profession  has  no  definite  terminol- 
ogy whereby  the  various  factors  of  business 
can  be  designated,  how  shall  we  blame  either 
the  business  man  or  the  law  maker?     Our 

104 


Making  Cost  and  Profit  Statements 

generosity,  however,  should  not  extend  beyond 
the  immediate  present.  There  will  be  little 
excuse  for  ignorance  a  year  hence. 

The  mutual  interests  of  both  the  Govern- 
ment and  business  will  be  served  by  a  better 
understanding  of  commercial  and  industrial 
terminology,  and  a  more  careful  usage  of  the 
terms. 

Whether  or  not  the  terminology  suggested 
in  the  last  chapter  of  this  book  is  adopted  is  of 
no  moment,  if  a  better  suggestion  can  be  of- 
fered and  accepted.  A  personal  element  should 
not  be  permitted  to  appear  in  the  matter. 

The  welfare  of  the  country  is  being  hamp- 
ered today  by  innumerable  discussions,  misun- 
derstandings, and  differences  of  opinion  as  to 
the  interpretations  of  certain  laws  and  rulings. 
The  need  for  better  terminology  is  also  appar- 
ent in  the  confusion  found  in  conventions  and 
other  meetings  of  business  men,  because  they 
do  not  speak  the  same  language  of  business. 

The  need  of  better  terminology  and  defi- 
nite fundamentals  was  recognized  by,  and  evi- 
dent in,  the  earnest  effort  of  Mr.  Edward  N. 
Hurley,  while  chairman  of  the  Federal  Trade 
Commission,  to  persuade  Associations  of 
Manufacturers  to  adopt  uniform  systems  of 
Cost  Calculation.    His  efforts  were  intended 

105 


Fundamentals  of  Cost  and  Profit  Calculation 

to  promote  an  understandable  language  of 
business,  but  his  use  of  the  word  "system"  was 
interpreted  by  many  as  referring  to  some 
specific  form  of  records.  This  misunder- 
standing nullified  much  of  his  effort.  What 
Mr.  Hurley  desired  was  not  uniformity  of 
mechanism  but  uniformity  in  principles  of 
calculation  and  presentation,  so  that  the  busi- 
ness men  of  the  country  and  the  Government 
could  all  understand  each  other  and  present 
confusion  be  eliminated. 

The   fundamentals   required   for  making 
Cost  and  Profit  Statements  are: 

1.  Definite  knowledge  of  what  is  cost,  and 

how  it  is  determined. 

2.  Definite  knowledge  of  receipts. 

3.  Definite  knowledge  of  what  constitutes 

income. 

4.  Definite  knowledge  of  what  constitutes 

earnings. 

5.  Definite  knowledge  of  what  is  profit, 
and  how  it  is  determined. 

6.  Definite  knowledge  of  what  constitutes 

assets. 

7.  Definite  knowledge  of  what  are  liquid 

assets. 

8.  Definite  knowledge  of  liabilities. 

106 


Making  Cost  and  Profit  Statements 

9.  Appreciation  of  the  necessity  for  re- 
serves  to  take   care  of   replacements, 
shrinkage,  etc.,  as  a  means  of  protecting 
'  the  invested  capital. 

Any  man  not  fully  informed  on  these  sub- 
jects, or  that  does  not  know  how  to  obtain  the 
information,  is  not  competent  to  make  up  a 
Cost  and  Profit  Statement. 

The  fact  that  practically  all  the  present  in- 
formation is  based  upon  the  use  of  traditional 
theories,  impractical  for  application  to  mod- 
ern conditions,  renders  the  problem  of  making 
Cost  and  Profit  Statements  very  difficult. 

Competent  Cost  Engineers,  having  many 
years'  experience  in  the  installation  of  Cost 
Engineering  Systems,  are  unanimous  in  their 
statement  that  of  the  hundreds  of  factory  or- 
ganizations they  have  served,  not  one  had,  in 
their  accounting  systems,  provided  for  all 
items  of  expense. 

That  being  the  case,  it  is  safe  to  assume 
that  because  of  the  traditions  of  accounting 
practice,  and  not  through  any  intent  to  mis- 
represent facts,  practically  every  financial 
statement  is  more  or  less  incorrect. 

But  a  small  percentage  of  factories  have 
cost  systems  designed  upon  modern  analytical 

107 


Fundamentals  of  Cost  and  Profit  Calculation 

or  Cost  Engineering  principles.  The  remain- 
der either  have  no  cost  system,  or  use  what 
purports  to  be  a  cost  system,  based  upon  the 
impractical  formulas  discussed  in  the  earlier 
chapters  of  this  book.  Such  systems  fre- 
quently vary  from  accuracy  as  much  as  twenty 
and  sometimes  thirty  per  cent. 

How  shall  a  man  be  able  to  develop  a 
practical  or  true  statement  of  earnings  or 
profits  if  he  does  not  know  how  to  correctly 
determine  the  cost  of  production  or  the  cost  of 
doing  business? 

How  shall  he  render  true  statements  if  he 
does  not  know  how  to  distinguish  between  re- 
ceipts and  income?  Or  if  he  confuses  the 
terms  "income,"  "earnings,"  and  "profits?" 

Nine-tenths  of  the  men  in  business  do  not 
know  how  to  determine  a  selling  price  that 
will  yield  a  certain  percentage  of  profit  after 
providing  for  the  cost  of  doing  business.  How 
then  shall  they  be  able  to  make  correct  state- 
ments covering  thousands  of  transactions  with 
varying  proportions  of  cost  and  profit? 

Bankers  are  familiar  with  the  fact  that  a 
large  percentage  of  business  men  are  ignorant 
as  to  what  constitutes  the  assets  and  liabilities 
of  a  business.  Nor  can  they  readily  distin- 
guish  the   characteristics,    important   to   the 

108 


Making  Cost  and  Profit  Statements 

banker,  which  cause  some  assets  to  be  classed 
as  "liquid." 

To  a  large  majority  of  manufacturers  the 
idea  that  reserves  should  be  set  up  in  cash 
seems  unimportant.  They  have  been  accus- 
tomed to  handling  depreciation,  if  at  all, 
through  the  profit  and  loss  account.  In  a  few 
instances  a  reserve  account  is  carried,  but  the 
actual  money  it  represents  is  used  in  the  busi- 
ness as  working  capital. 

Rarely  is  it  possible  for  concerns  using 
their  reserves  to  avail  themselves  of  the  cash  to 
purchase  new  equipment  to  replace  the  old. 

Where  cash  reserves  are  actually  carried 
there  is  a  feeling  of  confidence  engendered 
similar  to  that  of  the  man  who  realizes  that  he 
has  a  good  bank  account,  as  contrasted  to  the 
example  of  the  man  who  is  continually  work- 
ing on  his  last  dollar.  He  is  free  to  make 
plans  for  betterments  knowing  that  he  will  not 
have  to  worry  about  the  financial  side  of  the 
problem.  His  desire  to  hold  that  feeling  of 
independence  keeps  him  at  the  same  time 
from  foolishly  overequipping  his  plant. 

Doing  business  on  a  sound  basis  gives  a 
man  confidence  in  himself,  gives  him  a  clear 
head  for  progressive  plans,  makes  it  unneces- 
sary for  him  to  resort  to  misrepresentations 

109 


Fundamentals  of  Cost  and  Profit  Calculation 

and  subterfuges  in  his  Cost  and  Profit  Re- 
ports. 

The  live  business  man  of  the  hour  will 
study  modern  methods,  discard  traditions,  do 
business  on  a  basis  of  known  cost  and  profit, 
study  the  elements  of  business  so  that  he  can 
have  intelligible  records  for  his  own  use  in 
directing  his  own  affairs,  to  furnish  the  banker 
with  the  requisite  information  to  sustain  his 
credit,  and  to  give  the  Government  a  frank 
but  correct  statement  of  his  earnings. 

He  will  attain  such  a  degree  of  prosperity 
that  he  will  gladly  pay  his  share  of  the  burden 
of  tax  and  still  have  enough  for  his  own  re- 
quirements. 

Ignorance  spells  weakness.  Knowledge 
is  power. 


110 


CHAPTER  EIGHT 

THE  TERMINOLOGY  OF  COST 
ENGINEERING 

The  reader  has  found  in  the  preceding 
chapters  a  number  of  references  to  the  deplor- 
able fact  that  Commerce  and  Industry  have 
no  definite  and  recognized  terminology. 

Several  words  are  frequently  used  in  the 
same  sense,  while  again  the  same  word  is  used 
in  several  senses.  The  result  is  a  confusion  of 
terms  not  only  preventing  practical  transfer 
of  .information  between  individuals  who 
should  understand  each  other  but  unquestion- 
ably causing  a  serious  loss  of  money. 

The  term  "Profit,"  for  example,  is  fre- 
quently confused  with  earnings,  income,  mar- 
gin, and  dividends,  yet  each  of  these  words  has 
a  different  meaning. 

An  effort  has  been  made  in  preparing  this 
suggested  terminology  to  apply  to  each  word 
the  definition  that  seems  best  adapted  to  con- 
vey the  information  desired.  Practicability 
has  been  given  preference  over  the  common 
definitions  of  the  dictionaries.  For  example 
the  word  "profit"  is  defined  by  the  Century 
Dictionary  as  the  difference  between  the  first 

111 


Fundamentals  of  Cost  and  Profit  Calculation 

cost  or  purchase  price  and  the  price  for  which 
the  article  is  resold.  No  account  is  taken  of 
the  expenses  of  selling,  therefore  such  a  defini- 
tion, while  meeting  the  popular  conception  of 
profit,  is  not  practical  for  use  in  the  light  of 
modern  analysis. 

At  the  moment  of  writing,  the  business 
men  of  the  United  States  are  laboring  with  a 
serious  condition  due  to  confusion  of  terms. 
Taxes  on  incomes  and  profits  make  it  im- 
portant that  the  persons  affected  by  the  taxa- 
tion understand  fully  just  what  the  laws  mean. 

The  amount  of  discussion  and  the  differ- 
ences of  opinion  expressed,  makes  it  very  evi- 
dent that  grave  misunderstandings  exist,  and 
demonstrates  the  imperative  need  of  a  definite 
terminology. 

The  words  and  phrases  are  not  arranged 
alphabetically  in  the  appended  list  but  so  that 
the  definitions  of  those  generally  confused 
with  each  other  may  be  the  more  readily  com- 
pared. The  list  is  not  offered  as  a  complete 
terminology  but  contains  the  words  most  com- 
monly misused.  The  author  anticipates  a 
more  exhaustive  treatment  of  this  subject  at 
some  future  time. 

Receipts — The  total  of  money  or  negoti- 
able items  representing  money  received  dur- 

112 


The  Terminology  of  Cost  Engineering 

ing  a  period,  without  regard  to  either  ex- 
penses, earnings  or  profit. 

Income — The  remaining:  receipts  after  de- 
ducting the  cost  of  sales  and  all  other  expenses 
and  reserves  required  by  the  business.  It  may 
be  in  the  form  of  profits,  interest  on  invest- 
ments, royalties,  rentals,  investments  made 
within  the  period,  etc.  In  the  case  of  an  in- 
dividual it  may  also  include  salary,  commis- 
sions, dividends,  etc.  Income  should  not  in- 
clude estimated  increase  in  value  of  property 
or  increase  in  the  market  value  of  goods  held 
in  stock.  It  relates  only  to  receipts  and  may 
include  items  received  which  were  the  earn- 
ings or  profits  of  previous  periods. 

Earnings — ^Total  increase  of  assets  due  to 
the  activities  and  investments  of  the  business 
or  individual  whether  received  or  not.  Earn- 
ings become  a  part  of  income  only  when  the 
money  or  its  negotiable  equivalent  is  actually 
received.    Earnings  are  related  to  investment. 

Profit  of  Time  Period — The  amount  by 
which  the  total  sales  of  the  period  exceed  the 
total  cost  (not  purchase  price)  of  the  items 
sold.  Profit  is  always  net,  the  percentage  be- 
ing correctly  expressed  only  when  it  relates 
to  the  total  sales  of  the  period  as  the  base,  or 
one  hundred  per  cent. 

113 


Fundamentals  of  Cost  and  Profit  Calculation 

Profit  on  Transactions — The  amount  by 
which  the  selling  price  of  a  sold  item  exceeds 
its  cost.  Percentage  of  profits  is  correctly  ex- 
pressed only  when  it  relates  to  the  selling  price 
as  the  base,  or  one  hundred  per  cent.  Profit 
differs  from  margin  in  that  it  is  all  net  gain. 

Margin — The  percentage  by  which  the 
selling  price  exceeds  the  purchase  price  with- 
out relation  to  either  the  cost  of  doing  busi- 
ness or  the  percentage  of  profit  in  the  item. 
It  is  expressed  properly  when  the  purchase 
price  is  used  as  the  base  or  one  hundred  per 
cent.  Never  should  it  be  added  to  the  pur- 
chase price  as  a  means  of  determining  the  sell- 
ing price.    Erroneously  called  ^^gross  profit." 

.Gross  Profit — A  term  used  where  neither 
the  cost  nor  the  percentage  of  profit  is  known, 
to  designate  the  margin  between  purchase 
price  and  selling  price  of  merchandise.  It  is 
frequently  employed  by  persons  ignorant  of 
correct  methods,  as  a  means  of  determining  a 
selling  price.  Such  usage  is  frequently  pro- 
ductive of  losses  where  profits  were  intended. 

Selling  Price — ^The  price  which  a  cus- 
tomer is  expected  to  pay  or  does  pay  for  an 
item  sold.  In  all  calculations  of  profit  per- 
centages the  selling  price  represents  the  base 
or  one  hundred  per  cent. 

114 


The  Terminology  of  Ct)st  Engineering 

Turnover — The  total  of  the  sales  of  a  des- 
ignated period,  usually  a  year.  Used  princi- 
pally for  the  purpose  of  expressing  the  rela- 
tion of  the  total  sales  of  a  period  to  the  invest- 
ment used  in  the  business.  When  the  sales  of 
the  period  are  equal  to  the  investment,  the 
turnover  is  said  to  be  loo  per  cent.  If  they 
are  five  times  the  investment,  the  turnover  is 
500  per  cent,  etc. 

Investment — The  amount  of  money  em- 
ployed in  a  business  without  relation  either  to 
the  assets  or  the  ownership  of  the  money.  It 
includes  investment  in  realty  and  buildings 
used,  in  equipment,  merchandise  stocks,  work 
in  process,  if  a  factory;  accounts  receivable, 
reserves,  and  cash  in  bank  for  normal  require- 
ments of  the  business. 

Interest  on  Investment — The  wages  of  the 
money  employed  in  the  business.  It  is  a  part 
of  income  but  not  profit.  Being  included  in 
cost  of  production,  and  a  part  of  the  selling 
price  of  product,  it  must  be  deducted  from  re- 
ceipts before  profit  can  be  ascertained.  As  a 
part  of  income  it  must  be  included  in  income 
statements. 

Capital  Stock — The  amount  of  the  issued 
certificates  of  stock  of  a  corporation  calculated 

115 


Fundamentals  of  Cost  and  Profit  Calculation 

at  par.    Capital  stock  has  no  relation  to  invest- 
ment. 

Net  Worth — The  remainder  after  deduct- 
ing all  liabilities  from  the  total  of  assets.  Has 
no  relation  to  investment. 

Assets — The  property  of  a  person  or  cor- 
poration representing  investment  immediately 
or  eventually  convertible  into  money  for  the 
purpose  of  meeting  liabilities. 

Liquid  Assets — Items  of  assets  readily  con- 
vertible into  cash,  such  as  securities,  accounts 
receivable,  etc. 

Surplus — ^The  undivided  profits  of  the 
business.  Surplus  is  sometimes  employed  in 
the  business  as  capital,  and  sometimes  carried 
as  a  safeguard  against  embarrassment  because 
of  losses  at  unprofitable  seasons. 

Dividends — ^The  payment  made  to  stock- 
holders in  disbursing  the  earnings  of  the  busi- 
ness or  such  part  of  the  earnings  as  the  direc- 
tors of  the  corporation  decide  is  to  be  used  for 
dividends.  They  are  paid  to  stockholders  in 
the  ratios  of  stock  held  by  them. 

Wages — The  remuneration  of  employes 
whose  pay  is  calculated  at  a  rate  per  hour,  day 
or  week.  Wage  earners  forfeit  pay  for  time 
absent  or  not  used  in  the  service  of  the  em- 
ployer, but  are  paid  for  overtime. 

116 


The  Terminology  of  Cost  Engineering 

Salary — The  remuneration  of  employes 
whose  pay  is  calculated  per  month  or  year. 
Salaried  employes  do  not  forfeit  pay  for  holi- 
days, or  other  absences,  including  vacations, 
but  are  not  paid  for  overtime.  Salaried  em- 
ployes are  sometimes  paid  by  the  week.  In 
cases  of  willful  absence  purely  for  the  bene- 
fit of  the  employe,  the  employer  may  elect 
whether  any  or  no  payment  is  to  be  made 
for  the  period  of  absence. 

Commissions — The  remuneration  of  sales- 
men, when  they  are  compensated  in  the  ratio 
of  sales  of  goods  or  product. 

Cost — The  sum  of  the  expenses  involved  in 
the  production  and  distribution  of  an  item  up 
to  the  moment  at  which  cost  is  ascertained. 

Invoice  Price — The  price  shown  on  the 
invoice  without  regard  to  discounts,  or  ex- 
penses of  handling  and  selling,  which  must  be 
included  in  ascertaining  cost. 

Expense — Any  element  of  cost.  The  term 
is  sometimes  misused  as  the  title  of  an  account. 
Properly  used  it  should  always  be  preceded 
by  a  descriptive  title,  as  building  expense, 
wage  expense. 

Direct  Expense — An  element  of  cost  hav- 
ing but  one  beneficiary  to  which  alone  it  is 
chargeable  in  total. 

117 


Fundamentals  of  Cost  and  Profit  Calculation 

Indirect  Expense — An  element  of  cost 
having  two  or  more  beneficiaries  among  which 
it  must  be  distributed. 

Major  Direct  Expenses — Usually  the 
items  of  material  and  wages  which  may  be 
charged  directly  to  a  factory  order. 

Minor  Direct  Expenses — Direct  expense 
items,  such  as  repairs,  supplies,  etc. 

Immediate  Expense — An  item  which  be- 
comes a  recognized  liability  as  soon  as  in- 
curred and  paid  in  the  regular  course  of  busi- 
ness, as  rent,  insurance,  etc. 

Ultimate  Expense — An  item  of  expense 
necessarily  considered  in  cost  because  it  must 
ultimately  be  paid  although  there  is  not  likely 
to  be  an  insistent  demand  at  a  definite  date, 
as  replacement  reserve  to  counterbalance  de- 
preciation, interest  on  investment,  etc. 

Economic  Expense — Items  or  charges 
made  to  cover  the  normal  losses  of  business 
that  the  equilibrium  of  capital  may  be  main- 
tained, such  as  charges  required  to  cover 
shrinkage  of  stocks,  waste  in  cutting,  spoilage, 
depreciation  of  equipment,  good  will,  bad 
debts,  etc. 

Expense  Distribution — The  act  of  deter- 
mining the  amount  of  benefit  obtained  from 

118 


The  Terminology  of  Cost  Engineering 

an  indirect  expenditure,  by  the  several  bene- 
ficiaries, and  charging  each  with  that  propor- 
tion of  the  expense  item  represented  by  its 
proportion  of  benefit  derived. 

Process  Cost — The  result  found  by  divid- 
ing the  total  of  expenses  involved  in  a  process, 
over  a  given  period,  by  the  number  of  salable 
units  produced.  Usually  expressed  as  Process 
Hour  Rate. 

Cost  of  Production — The  cost  of  making 
an  item  of  product  without  consideration  of 
the  expenses  of  distribution  or  sale.  Cost  of 
production  is  the  total  of  Material  Cost  and 
Process  Costs  involved. 

Estimate — An  opinion  or  guess  as  to  the 
cost  or  probable  cost  of  an  item  already  man- 
ufactured or  to  be  manufactured.  Usually 
made  by  some  authorized  person  presumed  to 
be  informed  as  to  processes  and  their  cost 
and  competent  to  make  the  estimate. 

Quotation — ^The  amount  of  an  ofTer  or  bid 
to  furnish  specified  items  at  a  specified  price. 

Selling  Expense — All  items  of  expense  in- 
curred for  the  purpose  of  making  or  increas- 
ing the  sales  of  goods  or  product. 

Cost  of  Sales — The  total  cost  of  the  mer- 
chandise or  product  sold  in  a  designated  per- 

119 


Fundamentals  of  Cost  and  Profit  Calculation 

iod,  including  all  expense  elements  in  connec- 
tion therewith.  The  total  of  all  item  costs  for 
the  period. 

Replacement  Reserve — A  cash  reserve 
provided  by  including  in  the  cost  of  produc- 
tion of  all  items  a  charge  calculated  to  equal 
the  depreciation  of  equipment.  Included  in 
the  charge  for  product  it  becomes  a  part  of 
receipts,  when  payment  is  received,  and 
should  be  deducted  before  profit  is  calculated. 

Depreciation — Deterioration  or  shrinkage 
in  values  for  any  reason.  Commonly  used 
with  reference  to  wear  and  tear  on  machinery 
or  other  equipment.  All  assets  except  cash  are 
subject  to  more  or  less  depreciation.  The 
chief  causes  of  depreciation  are  obsolescence, 
inutility,  wear  and  tear,  neglect,  etc. 

Shrinkage — Commonly  used  with  refer- 
ence to  the  losses  or  depreciation  in  merchan- 
dise stocks,  caused  by  the  elements,  handling, 
theft  and  carelessness. 

Principle — A  principle  is  a  fundamental 
truth — a  comprehensive  law  or  doctrine  from 
which  others  are  derived,  or  on  which  others 
are  founded.  A  general  truth — an  elementary 
proposition.  There  can  be  no  exceptions  to 
the  application  of  a  fundamental  principle. 

120 


The  Terminology  of  Cost  Engineering 

Rule — A  rule  is  a  law  supposedly  but  not 
necessarily  having  as  its  basis  a  principle.  A 
rule,  unlike  a  principle,  is  subject  to  change 
under  certain  conditions. 

Unit — A  unit  is  one  of  the  parts  of  a  divis- 
ible thing  and  may  be  expressed  by  any  term 
denoting  weight,  measure,  or  count,  according 
to  the  nature  of  the  thing  to  which  it  is  ap- 
plied. 

Good  Will — A  trade-attracting  influence 
in  favor  of  a  concern  resulting  from  the  pol- 
icy of  delivering  to  each  customer  or  client,  in 
addition  to  the  requirements  of  his  order,  an 
element  of  unexpected  courtesy  or  service 
which  has  the  effect  of  not  only  causing  a  de- 
sire to  patronize  the  concern  again  but  to  tell 
others  about  it. 

System — A  plan  or  routine  intended  for 
the  purpose  of,  and  actually  having  the  effect 
of,  economizing  effort. 

Red  Tape — A  plan  or  system,  or  part  of  a 
plan  or  system,  requiring  for  its  operation 
either  unnecessary  effort,  or  unprofitable  ef- 
fort. If  the  cost  of  the  effort  equals  or  exceeds 
the  value  of  the  result  it  is  unprofitable  and 
consequently  *^red  tape.'' 

121 


INDEX  OF  TERMINOLOGY 


Assets    116 

Assets,  Liquid 116 

Capital  Stock 115 

Commissions    117 

Cost  ....117 

Cost  of   Production 119 

Cost  of  Sales ^ 119 

Cost,  Process 119 

Depreciation  120 

Direct  Expense 117 

Direct  Elxpense,  Major 118 

Direct  Expense,  Minor 118 

Distribution  of  Expense... .118 

Dividends  ^ 116 

Earnings 113 

Economic  Expense  118 

Estimate   1 19 

Expense ....117 

Expense,  Direct 117 

Expense,  Distribution  118 

Expense,  Economic  118 

Expense,  Immediate  118 

Expense,  Indirect   118 

Expense,  Major    Direct...ll8 
Expense,  Minor    Direct.... 118 

Expense,  Selling   119 

Expense,  Ultimate 118 

Good  Will  121 

Gross  Profit  114 

Income 113 

Immediate  Expense 118 

Indirect  Expense  117 

Interest  on  Investment — 115 


Investment 115 

Investment,  Interest  on 115 

Invoice  Price  117 

Liquid  Assets  .....116 

Margin 114 

Net  Worth 116 

Price,  Selling  114 

Price,  Invoice    ^ 117 

Principle  120 

Process  Cost 119 

Production,  Cost  of ..119 

Profit,   Gross 114 

Profit  of  Time  Period 113 

Profit  on  Transactions 114 

Quotation ....1 19 

Receipts 1 12 

Red  Tape  ^ 121 

Replacement  Reserve  120 

Reserve,  Replacement  120 

Rule 121 

Salary 117 

Sales,  Cost  of...., 119 

Selling  Expense 119 

Selling  Price 114 

Shrinkage!  120 

Surplus   1 16 

System  121 

Tape,  Red  121 

Turnover 115 

Ultimate  Expense 118 

Unit 121 

Wages  , 1 16 


122 


GENERAL  INDEX 

PAGES 

Accuracy,    Practical,   defined 75 

Accuracy,  prime  requisite  in  cost  system. 75 

Assets,  tendency  to  shrinkage 41 

Bases  of  Expense  Distribution ~ ...^ 79 

Capital,   source  of 52 

Contents    7 

Contingent  Expense,  fundamental  principle  of 69 

Cost,  defined 10 

Cost,  erroneous  usage  of  term 9 

Cost,  fundamental  principle  of 67 

Cost  Accounting,  origin  of - 29 

Cost  Engineering,  proof  of  practicability 36 

Cost  Engineering,  a  practical  science ^ 69 

Cost  and  Profit  Statements,  fundamentals  required.... 106 

Definiteness  the  keynote  of  Cost  Engineering 62 

Depreciation,    causes   of „ - 44 

Depreciation,  "charging  off'*  impractical ~ 46 

Depreciation,    items    for    consideration 47 

Dictionaries,  some  definitions  impractical 85 

Direct  Expense,  defined 19 

Economic  Expenses,  definition 42 

Effort,  the  rewards  for „ - 83 

Energy,  three  kinds  in  industries 41 

Estimate,   when   complete , SO 

Expense,   Contingent,  principle  of ^... 69 

Expense,  fundamental  principle  of 67 

Expense  Distribution,  Bases  of ~ 80 

Expense  Distribution,  Church  methods 31 

Expense  Distribution,  fundamental  principle  of 68 

Expense  Distribution,  makeshift  methods  of 30 

Expense  Grouping,  examples  of -. 76 

Expense  Grouping,  fundamental  principle  of 67 

Expenses,   Definite  and   Limited    ,. ^ 11 

Expenses,  Economic,  defined 42 

Elxpenses,   Immediate,   examples  of 38 

Expenses,  list  of 71 

Expenses,  primary  grouping  of 12 

Expenses,  related  to  Functions  of  Business 14 

Expenses,  Ultimate,  examples  of 3S 

Expenses,  when  possible  to  group 15 

Factory  and  Store  identical  in  principle 91 

Finances,  importance  to  industries.... 41 

Good  Will,   defined. _... 56 

123 


Fundamentals  of  Cost  and  Profit  Calculation 

PAGES 

Good  Will,  depreciation  of « .„ 47 

Good  Will,  discussion  of ~ 55 

Gross  Profit,  a  myth ^ , 18 

Immediate  Expenses,  examples  of -.  38 

Indirect  Expense,  defined 33 

Interest  on  Investment,  arguments  for 48 

Interest  on  Investment,  defined ^ 48 

Interest  on  Investment  not  part  of  profit 17 

Interest  Rates,  related  to  risk. 52 

Investment,    classification   of 54 

Labor-saving  Machines,  confusion  caused  by ^ 22 

Margin,   definition  of ^ 88 

Material  Cost,  what  is  included 81 

Material  Expense  not  related  to  Operating 23 

Overhead  accoimt  defeats  correct  efforts 14 

Overhead  Account,  measure  of  ignorance 35 

Patents,  Royalty  on 47 

Philosophy  of  Cost  and  Profit,  the 9 

Piecework  Wages,  not  an  aid  to  Costfinding 25 

Preface 3 

Principle,  invariable 36 

Process  Grouping,  fundamental  principle  of 68 

Process  Hour  Rate,  how  found 81 

Profit,  anticipation  not  justifiable 17 

Profit,  confused  with  Dividends ^ 98 

Profit,  defined — ..  15 

Profit,  related  to  Turnover 15 

Red  Tape,  contrasted  with  system 74 

Reserves,  importance  of 109 

Rules,  limitation  of   application ^ 36 

Schools,  impractical  teachings  of 51 

Selling  Price,  Basis  of  Profit  and  Selling  Expense.. 92 

Selling  Prices,  right  method  of  making „...  95 

Selling  Prices,  wrong  method  of  making 93 

Selling   Prices   and   Profits 83 

Statements,  Cost  and  Profit,  purposes  of 101 

Statements,  Financial,  frequently  wrong - ....107 

Stocks  and  Bonds,  relation  to  capital 52 

System  and  Red  Tape  contrasted 74 

Terminology  of  Business,  uncertainty  of - 60 

Ultimate  Expenses,  examples  of 38 

Wages,  not  basic  expense ~—  24 

War  Taxes,  basis  of  levy ~ ....104 

Wealth,  the  source  of ^ 41 

124 


BOOKS  BY  ROBERT  S,   DENHAM 

MANUAL  OF  COST  ENGINEERING 
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MANAGERS 

A  periodical  publication 

The  above  will  be  sent  free  on  request  of 
General  Managers  or  Corporation  Officers  of 
Manufacturing  concerns.  Will  not  be  sent  to 
accountants  or  clerks. 

Address  THE  DENHAM  COSTFINDING  CO.,  Cleveland 
126 


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THIS  BOOK  IS  DUE  ON  THF,  LAST  DATE 
STAMPED  BELOW 

AN  INITIAL  FINE  OP  25  CENTS 

WILL  BE  ASSESSED   FOR   FAILURE  TO   RETURN 
THIS   BOOK   ON   THE   DATE  DUE.   THE  PENALTY 
WILL  INCREASE  TO  50  CENTS  ON  THE  FOURTH 
DAY    AND    TO    $1.00    ON    THE    SEVENTH     DAY 
OVERDUE. 

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tcMH 

1939 

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mnti  '*fc  Jd&c 

LD  21-95w-7,*37 

YB  1852 


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